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Letters of Credit: How Does it Work & What Does it Mean Exactly?

Table of Contents

(Last Updated On: 2021年10月21日)

Letters of credit is basically a certificate issued by a bank that assures payment. But how does it work exactly? Reading through the following article you will find all you need to know about this method. We will describe what it is and why it is useful for safe business transactions. Besides we will explain how it works, how it is documented and what the money moving process is about.

Letters of Credit and its Many Names

Letters of credit or LOC have several names. Besides the primary name, bankers commercial credit or documentary credit are also used to refer to this payment method. This procedure is a safe way to conduct international commerce assuring both parties of financial security.

A Letter of Credit in an International Trade Transaction

The letter of credit can be used as the primary means of payment in international trade transactions. This is because it is an economically safe and trusted method of trading among both parties assured by their banks.

A Letter of Credit is Irrevocable

A letter of credit is a document from a bank that guarantees payment. This document is irrevocable in order to assure security for both parties. There are several types of letters of credit, and they can provide security when buying and selling products or services.

Seller Protection:
 
When the buyer cannot pay the seller, it is the bank that supplied the letter of credit that will have to pay the seller. This of course is the case only as long as the seller fulfills the conditions that both parties agreed upon previously. This is a secure method when the seller and buyer are in different countries.
 
Buyer Protection:
 
Buyers too can receive protection if they use letters of credit. If the buyer purchases a service or a product and the seller does not provide these, they can be paid using a standby letter of credit. This functions as a form of reimbursement that the buyer can use to purchase their goods from another source.

Why does the Seller Require a Letter of Credit?

LOC is fundamentally a letter in which a bank guarantees that the buyer’s payment will actually be received by the agreed deadline and for the right amount. Therefore it is safe to say that the primary reason for the seller to want a letter of credit is security.

A Guide on How it Works

Below we will describe the four key points and steps that characterise the process of conducting international trade using a letter of credit.
 

1. Decide to Do a Letter of Credit !

 
First things first: a seller and a buyer agree to do business together. Then they come to an agreement regarding all the conditions. This will include the quality, quantity and value of the services or goods and draw up the necessary conditions that both parties agree to. Such as when and how the goods or services will be shipped to the buyer. As part of the agreement, we presume that the seller asks the buyer to conduct the trade with LOC.
 

2.Issuing the LOC

 
When issuing the Letter of Credit, the buyer provides information that is required from the bank. This among others will include:
 
  • How much will the payment be exactly?
 
  • All of the contact information of the seller (also known as the beneficiary).
 
  • When will the goods provided by the seller be delivered to the buyer exactly?
 
  • In what way will the seller ship the product?
 
  • The exact location where the shipment should arrive.
 

Details Matter:

The more terms and conditions are expressed and elaborated, the better it is. In addition, it is also important to entail everything the parties might want to have included in their business transaction.

Funding:

An FFDLC or Fully Funded Documentary of Letter of Credit is a documented LOC that provides written proof that the seller will receive their payment for their goods or services. This is ensured by first and foremost the buyer. However, in the event of failing to do so, the bank takes economic responsibility.
 

The Money Behind a Letter of Credit

The money behind the LOC is supposed to come from the buyer of course. For this reason, before agreeing to issue the document, the bank will want to be absolutely sure that the buyer can pay for their purchases. At times, the buyer is required to pay to the bank before the trade and allow the bank to hold the money until the trade happens.

The Money Behind a Letter of Credit

 
 
The money behind the LOC is supposed to come from the buyer of course. For this reason, before agreeing to issue the document, the bank will want to be absolutely sure that the buyer can pay for their purchases. At times, the buyer is required to pay to the bank before the trade and allow the bank to hold the money until the trade happens.
 
When do Payments Happen?
 
The payment is mostly fast! If the payment is conducted using card or via the phone, it is instant. Payments started through the LOC Payment Portal might take up from 1 to 3 business days to go through.
 
Banks and Intermediaries:
 
As the third-party providing guarantee and documentation for LOC, banks will charge a fee for providing both the buyer and seller with their service. Intermediaries are companies that will help connect buyers to sellers. Using LOCs they facilitate trades.
 
Seller review:
 
Seller reviews are extremely useful for buyers in order to get an understanding of their performance and trustworthiness. Based on reviews, buyers can make conscious choices, keeping in mind their needs.
 
3.Sending Goods and Documents
 
In order to receive payment with a Letter of Credit, the seller has to satisfy the requirements specified in the document. This mostly means the following:
 
  • Shipping the goods by a certain date
 
  • Having the goods inspected before shipment
 
  • Using the shipping method specified in the Letter of Credit
 
  • Shipping exactly to and from ports specified in the document.
 
  • Collecting the required documents listed in the LOC (specific shipping documents, for example)
 
  • Submitting documents to the bank by a specific deadline
 
Seller Confidence:
 
The seller is confident that he or she will receive payment according to the agreement as long as the requirements in LOC are fulfilled.
 
Delivery not Required:
 
The seller might not be responsible for goods not being delivered depending on the terms entailed in the LOC.
 
Documentary Requirements:
 
The main challenge for the seller is to absolutely match every single requirement in the documentation. This is because banks will only pay if the conditions are fulfilled.
 
4.Payment and Shipment Arrive
 
When the required documents arrive at the seller’s bank, they verify it. Again, everything must match down to the grammar and every small detail. In other cases, the bank will refuse to pay. If everything else goes according to the conditions written in the LOC payments will be made from the buyer’s to the seller’s bank.
 
What Can Go Wrong?
 
Letters of credit make it very difficult to decrease risk even if you continue to conduct business. They can be very useful and practical tools. However, it is important to be focused and understand each and every detail precisely. A small error is already enough to cancel out the advantages of a Letter of Credit. Therefore when using Letter of Credit for accepting payments, you should be sure to:
 
  • Check each of the terms and conditions before making a decision and saying yes to the agreement.
 
  • Be clear about all of the documents needed. If anything is not perfectly clear, reach out to your bank.
 
  • It is important and easy to get the required paperwork in order to get the Letter of Credit.
 
  • Know the limitations regarding this mechanism and if they are rational and fitting to your needs.
 
  • Get information regarding the time frame within which your suppliers would provide you the documents required.
 
  • Be sure to return the documents to your bank before the deadline stated in the agreement.
 
  • Verify all documents needed by the Letter of Credit and see if they match with the Letter of Credit application exactly. Even typos, or common substitutions can result in issues.

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