What is Letter of Credit? Types and Real-Life Uses

To explain what a Letter of Credit is, you should remember these three parties and the environment:

• Seller
• Buyer
• Bank
• International trade

In the international business scene, just like anywhere else, a seller can be worried about not being paid by the buyer after delivering the goods or service of the deal. This is because, under normal circumstances, money is paid after the seller has delivered.

But, what if the buyer fails to pay him?

That's where the Letter of Credit (LC) comes into play.

Remember the bank above? Yes, the bank can assure the seller that the buyer will pay him on delivery of the service or commodity. Here, the bank is stepping in to guarantee that it will pay the money on behalf of the buyer - thereby giving some confidence to the seller to carry on.

Before a Letter of Credit will be issued by a bank, the buyer must approach the bank with the transaction before him. After checking the financial status of the buyer, the LC is issued to the seller.

By definition, a Letter of Credit (LC) is a financial document issued by a bank or financial institution that guarantees that the seller will receive his payment on time and for the correct amount. In the event that the buyer is unable to make payment for the purchase, the bank or financial institution will cover the full or remaining amount owed. LCs are used primarily in international trade transactions to mitigate the risks involved when dealing with unfamiliar parties and varying laws across countries.

How Does a Letter of Credit Work

Here’s how it works:

1. The buyer and seller agree to conduct a transaction where the payment will be made through an LC.
2. The buyer applies for an LC from their bank (issuing bank).
3. Once the bank approves the application, it issues the LC and sends it to the seller's bank (advising bank or confirming bank), which then informs the seller.
4. The seller ships the goods to the buyer and provides the shipping documents to their bank.
5. The seller's bank checks the shipping documents against the LC terms. If compliant, these documents are sent to the buyer's bank.
6. The issuing bank reviews the documents, and if they comply with the LC terms, makes the payment to the seller's bank, which in turn pays the seller.
7. Once payment is made, the buyer's bank provides the shipping documents to the buyer, enabling them to claim the goods from the carrier.

Different Letters of Credit and Case Studies

There's a bunch of different letters of credit out there, each designed for different kinds of trade situations and needs:

1. Commercial Letter of Credit

This is the most common type of LC, where the bank promises to pay the beneficiary a set amount of money within a specified time frame, assuming all terms of the agreement are met. It is primarily used in international trade transactions.

A U.S. electronics retailer is purchasing televisions from a manufacturer in South Korea. The retailer uses a commercial LC to ensure the manufacturer receives payment once they provide proof of shipping the televisions.

2. Standby Letter of Credit

Functions as a backup payment mechanism, used primarily in the US. It is a guarantee by the bank to pay the beneficiary in the event that the applicant fails to fulfill their contractual obligations.

A construction company in Canada is contracted to complete a building in the United States. The company obtains a standby LC from their bank to assure the U.S. partner that compensation will be provided if the construction project is not completed as per the contract terms.

3. Revolving Letter of Credit

Designed for businesses that require multiple shipments over a period of time. It allows the amount under the LC to be reused for a certain period, eliminating the need for issuing a new LC for each shipment.

A clothing retailer in France orders fabrics regularly from India. A revolving LC is set up to cover multiple shipments over the year, refreshing the credit limit each time a payment is made, avoiding the need for a new LC for each shipment.

4. Transferable Letter of Credit

Allows the original beneficiary (usually a middleman) to transfer all or part of the proceeds to another party (usually the actual supplier of goods). It is useful in transactions involving intermediaries.

A trading company in Singapore acts as a middleman, purchasing olive oil from producers in Spain to sell to buyers in Japan. The company uses a transferable LC to pay the Spanish producers by transferring a portion of the LC received from the Japanese buyers.

5. Irrevocable Letter of Credit

Cannot be amended or canceled without the agreement of all parties involved, including the issuing bank, the applicant, and the beneficiary. This gives the beneficiary a stronger assurance of payment.

A Brazilian coffee exporter sells a large shipment of coffee beans to a distributor in Italy. An irrevocable LC ensures the exporter will get paid as long as they ship the coffee and meet all other terms specified in the LC.

6. Confirmed Letter of Credit

Adds an additional guarantee on the LC by another bank, usually in the seller's country. This provides the seller with a higher level of security, as it reduces the risk associated with the issuing bank's country's political stability and creditworthiness.

A small manufacturing company in Egypt is exporting goods to a buyer in Russia. Due to concerns over political instability and the financial situation in Russia, the Egyptian company requests a confirmed LC from a European bank to add an extra layer of payment security.

7. Sight Letter of Credit

Requires the issuing bank to pay the beneficiary immediately upon presentation of the specified documents that prove the goods were shipped or services were provided.

An Australian winery exports a shipment of wine to a retailer in China. The winery is paid immediately upon presenting the shipping documents to the bank under a sight LC, ensuring quick payment after shipment.

8. Deferred Payment Letter of Credit

Also known as a usance letter of credit, allows for a deferred payment to be made to the beneficiary, providing terms for payment at a later date after the documents are presented, typically after the buyer has received and sold the goods.

A machinery supplier in Germany sells equipment to a manufacturing plant in Brazil, agreeing that payment will be made 90 days after shipment. A deferred payment LC allows the Brazilian company time to receive and use the machinery before making payment.

9. Red Clause Letter of Credit

Contains a clause that allows the seller to receive an advance before shipping the goods. This is typically used to finance the production of the goods that are to be shipped.

A Kenyan agricultural producer needs upfront financing to harvest and prepare coffee beans for export to a European buyer. A red clause LC allows the producer to receive an advance against the LC to cover these initial costs before shipment.

10. Green Clause Letter of Credit

Similar to the Red Clause LC, but with an additional provision that allows for an advance to be used specifically for the storage, warehousing, or accumulation of the goods before shipment.

A Peruvian miner needs funds to extract and store copper before shipping it to a buyer in Japan. A green clause LC provides an advance not only for the mining operations but also for storing the copper securely until it's ready for shipment.

Conclusion

Letters of credit are basically a financial wingman for businesses when they're dealing with transactions, especially the international ones where trust levels can be as unpredictable as the weather. It's like having a financial safety net that says, "We got you covered," ensuring sellers get their money as long as they play by the rules, and buyers get their goods or services without the seller bailing last minute. 

From the old commercial LCs that cover straightforward buy-and-sell deals, to the more niche ones like red and green clause LCs that help sellers with upfront costs, there's an LC out there for almost every trade scenario you can think of. This whole setup not only makes global business ventures less of a headache but also opens up opportunities for companies to explore new markets with less risk. Pretty neat, right?