by A letter of credit (LC), also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods. Letters of credit are used extensively in the financing of international trade, where the reliability of contracting parties cannot be readily and easily determined. Its economic effect is to introduce a bank as an underwriter, where it assumes the counterparty risk of the buyer paying the seller for goods.
A letter of credit is a document from a bank that guarantees payment. There are several types of letters of credit, and they can provide security when buying and selling products or services.
- Seller protection: If a buyer fails to pay a seller, the bank that issued a letter of credit must pay the seller as long as the seller meets all of the requirements in the letter. This provides security when the buyer and seller are in different countries.
- Buyer protection: Letters of credit can also protect buyers. If you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit. That payment can be a penalty to the company that was unable to perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.
If you’re familiar with escrow services, the concept is similar: Banks act as “disinterested” third parties. The bank doesn’t take anybody’s side, and banks release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also helpful for domestic transactions like construction projects.
Example
- A manufacturer receives an order from a new customer overseas. The manufacturer has no way of knowing if this customer can (or will) pay for the goods after producing and shipping the products.
- To manage risk, the seller uses an agreement that requires the buyer to pay with a letter of credit as soon as shipment is made.
- To move forward, the buyer needs to apply for a letter of credit at a bank in their home country. The buyer may need to have funds on hand at that bank or get approval for financing from the bank.
- The bank will only release funds to the seller after the seller proves that the shipment happened. To do so, the seller typically provides documents showing how goods were shipped (with details like the exact dates, destination, and contents). In some ways, the buyer also enjoys protection under a letter of credit: Buyers might prefer to pay a bank with a big legal department rather than send the money directly to an unknown seller.
- If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released.
The Money behind a Letter of Credit
A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if the bank is confident that the buyer can pay. Some buyers must pay the bank up front or allow the bank to freeze funds held at the bank. Others might use a line of credit with the bank, effectively getting a loan from the bank.
Sellers must trust that the bank issuing the letter of credit is legitimate and that the bank will pay as agreed. If sellers have any doubts, they can use a “confirmed” letter of credit, which means that another (presumably more trustworthy) bank will guarantee payment.
When Does Payment Happen?
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For international trade
The seller may have to deliver merchandise to a shipyard to satisfy the requirements of the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that they made delivery, and the documents are forwarded to the bank. In some cases, simply placing the shipment on board a vessel triggers the payment, and the bank must pay even if something happens to the shipment. If a crane falls on the merchandise or the ship sinks, it’s not necessarily the seller’s problem.
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Documents matter
To approve payment on a letter of credit, banks simply review documents proving that a seller performed any required actions.
The bank is not concerned with the quality of goods or other items that may be important to the buyer and seller. That doesn’t necessarily mean that sellers can send a shipment of junk: Buyers can insist on an inspection certificate as part of the deal, which allows somebody to review the shipment and ensure that everything is acceptable.
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For a “performance” transaction
A beneficiary (the buyer, or whoever will receive the payment) might have to prove that somebody failed to do something. For example, a city might hire a contractor to complete a building project. If the project is not completed on time (and a standby letter of credit is used), the city can show the bank that the contractor did not meet his obligations. As a result, the bank must pay the city. That payment compensates the city and makes it easier to hire an alternative contractor to finish the work.
