Letters of credit definition, explanation with an example

Letter of Credit explained
What is a letter of credit?

A Letter of Credit (LC) is a document issued by your bank that essentially acts as an irrevocable guarantee of payment to a beneficiary. This means that if you do not perform your obligations, your bank pays. The letter of credit can also be the source of repayment of the transaction meaning that the exporter will get paid with the redemption of the letter of credit.

Let me give you an example:

For simplicity sake lets imagine that your company imports radios from a Korean manufacturer called Seoul Manufacturing, which banks at First Seoul Bank. Your company currently banks at First American Bank

For the purpose of this example these will be the roles that the parties will play in the letter of credit transaction:

Your company : applicant
Seoul Manufacturing : beneficiary
First American Bank : Issuing Bank
First Seoul Bank : Advising Bank

The example: You want to buy $50,000 worth of radios from Seoul Manufacturing, which agrees to sell the merchandise and gives you 60 days to pay it with the condition that you provide them with a 90 days letter of credit for the full amount. The steps to get the LC would be as follows:

1)You go to First American Bank and request a $50,000 letter of credit with Seoul Manufacturing as a beneficiary.

2)The bank goes through its underwriting process. Although the bank is not advancing money, they are extending credit on your behalf and are taking on a contingent liability. If your company qualifies from a credit standpoint the LC is issued.

3)Even if your company does not qualify for credit, you can still get an LC if you are willing to put cash collateral CD secured letters of credit are very common for small business .

4)The bank sends a copy of the letter of credit to First Seoul Bank, which lets the vendor knows and the merchandise is shipped.

Take into consideration that the letter of credit itself might be the source of repayment of the transaction. It could be that Seoul Manufacturing is interested in getting paid as soon as the merchandise is shipped. Therefore, the letter of credit will indicate that payment shall be made as soon as Seoul Manufacturing can present proof of shipping.

If the letter of credit that your vendor requires is not tied to a particular transactions, but they are asking for a guarantee that makes sure that you will not default. They are probably asking for a Stand-By letter of credit or a Revolving letter of credit. These types of LCs are usually for a longer term. Usually a year and are the vendor?s guarantee that they will get paid.

The example above describes the simplest of letter of credit transactions. Although there are other factors involved such as the role of correspondent banks and confirmations, the thing that you should be concerned as a customer is expediency and the fees involved, which can run anywhere from 1.5% to 8% of the value of the LC

TYPES OF LETTERS OF CREDIT

Revocable letter of credit

Just like the name says the LC can be revoked by the Issuing Bank without the agreement of the beneficiary.

Irrevocable letter of credit

Can not be cancelled or amended without all the parties agreement.

Standby letter of credit

Guarantee of payment. If the beneficiary does not get paid from its customer it can then demand payment from the Bank by forwarding the copy of the invoice that was not paid and supporting documentation.

Revolving letter of credit

It is established when there are regular shipments of the same commodity between supplier and customer. Eliminates the need to issue an LC for each individual transaction

I decided to put a link to a book that has a comprehensive chapter on letters of credit, and additional information about trade financing. I have heard good things about it, and you might want to consider buying it. The Handbook of International Trade and Finance: The Complete Guide to Risk Management, International Payments and Currency Management, Bonds and Guarantees, Credit Insurance and Trade Finance

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