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What Is a Letter of Credit?

A letter of credit is a guarantee from a bank against risk for a seller that their buyer will pay. It is common in international trade.
The guarantee is that payment will be the correct amount and will be paid within a set time frame. In return for providing the letter of credit, banks or lenders usually will require certain documents of proof like shipping confirmation.

what is a letter of credit - satisfied business owner with a letter of credit

International trade can be tricky but a letter of credit can add security for both parties.

  • As an importer, there is always a risk of non-delivery of goods
  • As an exporter, the risk is that shipped goods aren’t paid for

Simply put, a letter of credit is a guarantee from a bank or finance provider. It guarantees that a particular buyer will pay a particular supplier on time and in full.

When can a letter of credit be used?

Letters of credit are used in international trade where there is often a long lag between dispatch and delivery of goods. While the exporter wants payment early, the importer likes to see the product before paying.

If your company frequently trades overseas, you’ve probably come across them before. But did you also know that some funders for trade finance and import/export finance might require one from you as well?

While using a funder for trade finance or import/export finance to improve your company’s cash flow, there’s essentially another party involved who will need a guarantee that the money they are providing for the financing agreement will be repaid.

What are the costs?

Because the bank or lender is giving security that money will be paid or received, they will charge a fee. This is usually a percentage of the amount covered by the letter of credit.

For example, if your bank or lender charges 1% for the letter and the amount the letter is covering is £100,000, you’ll pay £1,000 in fees.

Types of letter of credit

The most commonly used types are:

  • Irrevocable
    Unless everyone in the process agrees, an irrevocable letter of credit cannot be cancelled or changed. This means it provides a little more security than a revocable one.
  • Revocable
    This type can be changed or cancelled at any time by the issuer.
  • Confirmed
    Once the buyer’s bank has issued the letter of credit, the seller can opt to have it confirmed by a bank of their choosing. This also provides more security than leaving it unconfirmed.
  • Unconfirmed
    As the name might suggest, this is a letter of credit that has been issued but not confirmed by a second bank.
  • Transferable
    If there are intermediaries working in the transaction between buyer and seller, the letter of credit can be passed between parties on the receiving end of payment.

Combinations of the above five types are also available, like a confirmed and revocable. In addition to the types already listed, other types include:

  • Standby
    If the seller doesn’t expect to have to draw on a letter of credit but would like security just in case, they can have this in the form of a standby letter of credit from the buyer.
  • Revolving
    If the buyer and seller expect to have a longer lasting relationship and multiple transactions, then a revolving letter is useful for covering more than one transaction.
  • Back-to-back
    A back-to-back letter of credit can be used when intermediaries are involved beyond just the buyer and seller. Those intermediaries might be brokers or other beneficiaries for example.

Benefits for sellers

As a seller, a letter of credit is a guarantee that you’ll receive all the money due, on time. You have a sense of security surrounding the payment. Provided that all terms and conditions are met, as all the risk is transferred to the bank or funder providing the letter instead.

They’re also useful if you’re looking to secure financing. Some trade finance providers will ask for one before finalising the facility. Once you have it all in place, you could be in a better position to purchase materials and supplies to fulfill orders.

Benefits of a letter of credit for buyers

Buyers with a letter of credit can guarantee that they’ll receive the goods they’re paying for. Therefore, the risk of being out of pocket with nothing to show for it is reduced.

What is UCP 600?

UCP 600 (Uniform Customs & Practice for Documentary Credits) is the set of standards that govern the use of letters of credit. The rules were put in place by the International Chamber of Commerce. Typically, users of letters of credit don’t need to know all the rules, but it can be reassuring to know they are there!

 

What next?

To discuss international trade finance, please get in touch with us and our team will help you out.

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