What is a Letter of Credit?
A letter of credit is a letter from a bank that guarantees payments. The bank assumes the responsibility for the payment on behalf of a buyer, also the bank’s customer. It makes the guarantee to a seller or the seller’s bank. Usually, letters of credit involve various parties. Similarly, these are most prevalent for transactions between parties from different countries.
If the buyer fails to make the payment on the purchase transaction, the bank will cover the full or remaining amount. It is because the bank acts as the guarantor and must assume responsibility for the transaction. The seller receives their payment either way. Usually, banks offer a letter of credit as a facility as they are not loans, in essence.
As mentioned, letters of credit are a requirement for almost all international transactions. By involving a bank in a transaction, both the seller and buyer can benefit. For the seller, the benefit comes in the form of a guarantee of payment. For the buyer, the primary advantage is that they can make international transactions without restrictions.
How do Letters of Credit work?
Letters of credit start from a financial institution that offers the facility. A customer who wants to make an international purchase may approach the bank for the facility. Letters of credit work for domestic purchases as well, although they are not as commonly used. Once the customer avails of the facility, they will provide the transaction details to the financial institution.
The bank or financial institution that offers the facility then contacts the seller or their bank. The bank provides them with a guarantee that the seller will get paid. Once the seller receives the guarantee, they can send the goods to the buyer. Usually, it takes some time for the goods to reach the buyer.
When the buyer receives the goods, they can let the bank clear the payment and send it over to the seller. However, sellers can also ask the bank for their payment once they meet certain predefined criteria. For example, sellers may request to get paid once the goods get delivered to the buyer’s location or country. This way, sellers don’t have to wait for the buyer to release the payment.
Which parties are a part of a Letter of Credit?
Four different parties usually take part in a letter of credit. These are as below.
Applicant or Buyer
The applicant or buyer is the individual or company that requests the letter of credit facility. It is also the entity that is ultimately responsible for the payment.
Issuing Bank
The issuing bank is the bank that provides the letter of credit facility. Usually, it is the applicant’s bank. The issuing bank also guarantees the payments to the seller or their bank.
Negotiating bank
The negotiating bank is the bank that works with the beneficiary. The negotiating bank deals with the issuing bank on the seller’s behalf. In some transactions, there may not be any negotiating banks at all.
Beneficiary or Seller
The seller is the entity that sells the goods. Due to any reason, they may prefer payments to come from banks rather than other entities. The seller is the party that ultimately receives the payment.
Other parties
The above are the primary participants in a letter of the credit transaction. There may be some other parties as well that may take part in the transaction. For example, these may include the confirming bank, shipper, intermediary, legal counsel, etc.
Conclusion
A letter of credit is a bank facility. Through this facility, banks act as a guarantor on behalf of a buyer to a seller. These are most common in international transactions, where they may be a requirement. Usually, a letter of credit transaction involves four parties, although there may be more.
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