A letter of credit (LC) is an effective financial payment method designed to ensure secure cash flow in international trade. It is often preferred to eliminate trust issues that may arise between commercial parties operating in different countries. In this system, the buyer’s bank undertakes to make payment to the seller provided that the defined conditions are met. In this way, the interests of both the buyer and the exporting party are protected.
An LC is structured in a way where mutual obligations are clearly defined, and transactions are secured through documentation. Playing a critical role in reducing the risks of cross-border trade, it is especially prominent in high-value and large-scale transactions. This article will examine in detail what a letter of credit is, the types used in practice, how it is opened, the role of banks in the process, and common mistakes made during implementation.
Definition and Importance of a Letter of Credit
A letter of credit is recognized as one of the most reliable payment methods in international trade, providing confidence between parties and securing commercial transactions. It helps overcome the lack of trust that may exist between buyers and sellers in cross-border trade. In this system, the buyer’s bank guarantees payment to the seller once specific conditions are fulfilled.
This guarantee is documented in writing and usually requires that goods are delivered on time, in full, and that all necessary documents are properly submitted. For exporters, it provides assurance of payment once goods are shipped. Since it only becomes effective when the agreed terms are met, it also protects buyers. Thus, an LC stands as a secure commercial tool for both sides.
Types of Letters of Credit
The types of LCs used in international trade vary depending on the parties’ needs, the nature of their relationship, and contract details.
- Irrevocable Letter of Credit: Once issued, it cannot be unilaterally canceled by the buyer or the bank. It provides strong assurance to the seller.
- Revocable Letter of Credit: May be modified without the consent of one of the parties, but due to trust concerns, it is rarely preferred.
- Transferable Letter of Credit: Suitable for intermediary companies in a trade chain. The first beneficiary can transfer the LC to another beneficiary, offering flexibility in supply chain management.
- Back-to-Back Letter of Credit: A secondary LC is issued based on an existing one, often used in complex transactions and between importing and exporting companies.
Each type operates on specific documentation and helps clarify the obligations of the parties in the export process.
The Process of Opening a Letter of Credit
An LC transaction usually begins at the request of the importer (buyer). First, the buyer applies to their bank with a request to open an LC based on a sales contract. This application specifies the payment method, shipment period, and required documents.
The buyer’s bank then issues an LC letter to the seller’s correspondent bank. After receiving the documents, the seller prepares the goods, arranges shipment, and submits the required documents according to the agreed payment method. Once the bank verifies the accuracy and compliance of these documents, payment is released.
Any mistake or delay in the process—such as missing documents—may cause a delay in payment or result in non-payment altogether. For this reason, it is vital that all parties fulfill their obligations accurately and on time.
The Role of Banks and Cost Elements
In LC transactions, banks act not only as payment intermediaries but also as checkpoints for control and security. Each LC transaction involves at least two banks: the issuing bank (the buyer’s) and the advising/confirming bank (the seller’s).
The issuing bank guarantees payment, while the seller’s bank checks the accuracy of documents and facilitates collection. During this process, banks charge various fees such as opening fees, notification fees, document examination and verification charges, and general commissions.
It is crucial that these costs are agreed upon in advance and clearly stated in the contract. Otherwise, disputes may arise during the export process. Transparent cost-sharing is essential for smooth operations.
Common Mistakes in LC Transactions
Although LCs are among the safest payment methods, certain mistakes during implementation can cause losses for the parties involved.
- Incomplete or incorrect documentation: The most common mistake, which can block payment until corrected.
- Goods not matching LC terms: Variations in quality, quantity, or shipment deadlines may invalidate payment.
- Misunderstanding bank procedures: Failure to comply with documentary submission deadlines can disrupt the process.
- Unclear payment terms: Not specifying payment details clearly in the contract increases risks for both parties.
To avoid these issues, companies should seek professional consultancy, follow procedures carefully, and ensure all stakeholders understand their responsibilities. Proper planning and time management significantly improve the success rate of LC-based transactions.
