Letter Of Credit

Reviewed by Bhavana | Updated on Aug 27, 2020

Introduction to Letter of Credit

It is a letter via a bank that guarantees that the payment of a buyer to a seller would be received on time for the correct amount. Should the purchaser be unable to make a payment on the purchase, the bank would be forced to cover the complete or remaining purchase sum. This can be provided as an installation.

Letters of credit have become a significant part of international trade due to the complexity of international relations, including factors, such as distance, different laws in each region, and difficulty in understanding each party personally.

Types of Letter of Credit

  • Revolving Letter of Credit: This form of the letter allows a customer to make any number of drawings within a defined time-limit.

  • Commercial Letter of Credit: This method encourages a direct payment to the beneficiary made by the issuing bank. A standby letter of credit, by comparison, is a secondary form of payment in which the bank only pays the recipient when the holder cannot.

  • Confirmed Letter of Credit: A verified credit letter involves a bank other than the issuing bank, which guarantees the credit letter. The second bank is the bank which confirms, typically, the bank of the seller. If the holder and the issuing bank default, the confirming bank ensures payment under the letter of credit. The issuing bank usually demands this agreement in the context of international transactions.

  • Traveler's Letter of Credit: This letter guarantees those going abroad that issuing banks will honour drafts made at some foreign banks.

How Does a Letter of Credit Function?

Since a letter of credit is usually a negotiable instrument, the issuing bank pays the recipient or any bank that the recipient nominates. If a credit letter is transferable, the beneficiary may delegate the right to draw to another person, such as a corporate parent or a third party.

Banks also collect a service fee, which is typically a percentage of the credit letter size. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits supervises credit letters that are used in international transactions.