Have you ever been confused by what a letter of credit is? Or ever asked why you need it in international trade? or probably wish to understand in detail the various payment methods in international trade. Mostly as an exporter who might have experienced the use of this payment method, you would have come across some complex situation that requires further understanding of the subject of international trade. Or probably you’re reading this article as a beginner, then you’re in the right place.
The article will discuss what a letter of credit is, how it works, what it is used for. In another article, we discussed the types of letters of credit, as well as the benefits associated with them, and more!
What a Letter of Credit is?
Investopedia defines a letter of credit as “a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount”.
It is used when the importer and exporter cannot agree on a payment method, or if the goods are perishable and need to be shipped immediately.
A letter of credit transfers money from the bank that issued it to another account in another country with no physical exchange of currency happening. The recipient then withdraws money as needed until all terms have been met by both parties involved.
It functions as an assurance from the buyer’s bank that the seller will be paid after they complete their end of the obligation. Letters of credit are issued by banks and guarantee payment to the seller for goods shipped within a certain period of time.
Read More: Payment Methods in International Trade
Why Do you need Letters of Credit in International Trade?
If you’re not familiar with international trade, let me get you up to speed.
International trade is simply transactions of goods and services between two parties in different parts of the world. There are many countries so it becomes difficult to keep an eye on all other parties involved. This is where Letters of Credit come into the picture.
The letter of credit is almost always required by the buyer but can be used in sales to a particular region or country. A Letter of credit requires that the purchase order has been received and confirmed before a letter is issued, and it also specifies an exact time frame for shipping.
The Letter of credit transfers the payment from the buyer’s bank to the seller’s upon proof that the buyer has received their product. Letters of credit are almost always created between banks instead of only one party, due to the guaranteed nature of it.
Letter of Credit as a Financing Tool
Letters of credit are used by importers and exporters alike as a way to transfer money across the world without making expensive international transfers.
They are issued by banks upon request from an importer or exporter to ensure that their client purchasing the product will be able to pay the seller. The bank involved in issuing a letter of credit also ensures that it can be paid by the buyer before releasing the funds to the seller.
The letters of credit are beneficial to exporters because they eliminate the risk associated with international trade, reduce counterparty credit risks, provide security against currency fluctuations, and serve as an efficient financing tool.
Who Uses Letters of Credit in International Trade?
Almost everyone who does international trade will have a need for letters of credit at some point in their career!
It’s a useful way to transfer money without worrying about currency fluctuations and other counterparty risks.
There are different types of letters that vary from bank to bank but the most common is the clean letter of credit.
A clean letter is a payment guarantee from a buyer’s bank for goods shipped from a seller overseas. Letters of credit are usually required by the buyer but can be used as a selling tool to a specific region or country.
Read Also: Type of Letter of Credit
When are Letters of Credit Used?
Letters of credit can be used in many situations but are primarily used for international trade to protect invoices, transactions and shipments.
They’re often used by buyers or sellers who don’t have a working relationship with the other party because the bank involved will verify whether both parties
How does the process work for a Letter of Credit?
In most cases, before an exporter agrees to the sale of goods to a buyer, they will require that the buyer obtain a letter of credit from their bank.
When an exporter agrees to these terms, this letter is known as the supplier’s acceptance. It serves as a confirmation of both parties’ agreement on all conditions stated in the letter.
The bank then proceeds with all the appropriate arrangements to ensure that both parties are protected in case anything goes wrong.
If everything is done as it should be and the payment is released by the buyer upon arrival of a shipment, then the institution will release monies requested by the exporter once they receive their original documents (a commercial invoice, bill of lading and certificate of origin).
Completion of Instructions for Letters of Credit
There are three parties to any letter of credit transaction: the issuing bank, the advising bank and the beneficiary.
If you use a letter of credit correctly it will open up your international business opportunities since there is no need to worry about the bank taking advantage of you.
First, determine who is issuing the letter and who will be receiving it in order to select an appropriate bank for this transaction. Also ensure that your bank is not only familiar with letters but is also aware of any legal standards or guidelines specific to your industry at large because if they are not, they might let major loopholes slip through the cracks!
Finally, make sure all pertinent documents are in place before sending them off – including any additional documents required by your bank’s policies. If everything goes well, you may receive a confirmation statement from the advising bank upon receipt of shipment. At this point, both parties should receive their money minus the commission fees charged by the banks involved in this transaction process.