A letter of credit, also known as a credit letter, is issued by a bank to guarantee that a buyer’s payment to a seller will be made on time and for the agreed amount. Should the buyer fail to pay, the bank steps in to fulfill the payment obligation. Letters of credit are particularly significant in international trade where trust between parties may be lacking due to distance, differing laws, and the challenges of cross-border transactions.
Key Takeaways
- A letter of credit guarantees on-time, full payment to the seller by the bank.
- Predominantly utilized in international trade.
- Multiple types of letters, including revolving letters of credit.
- Banks charge a fee for this service.
How a Letter of Credit Works
When a buyer requires major purchases, they might employ a letter of credit to offer assurance to the seller. A bank issues this letter to ensure the seller receives payment, either directly or via another nominated bank. Before approval, the bank assesses the buyer’s assets or line of credit and often demands securities or cash as collateral.
How Much a Letter of Credit Costs
Banks levy charges based on a percentage of the total credit assured by the letter. The exact fee varies by bank and letter size but typically it’s around 0.75%. More complex letters, such as confirmed letters, which use a second bank’s guarantee, may incur higher fees.
Types of Letters of Credit
- Commercial Letter of Credit: Direct payment method where the issuer (the bank) pays the seller directly.
- Revolving Letter of Credit: Allows multiple draws within a set limit and timeframe, suitable for repeated transactions.
- Traveler’s Letter of Credit: Guarantees payments at certain foreign banks when traveling internationally.
- Confirmed Letter of Credit: Involves a second, confirming bank to guarantee payment if the primary bank/named person defaults.
- Standby Letter of Credit: Acts like insurance, guaranteeing payment only if certain criteria fail to be met.
Example of a Letter of Credit
Consider a business in Latin America seeking imports. Citibank can issue a letter of credit ensuring payment to exporters by its branch, mitigating country and commercial credit risks.
How to Apply for a Letter of Credit
- The importer’s bank reviews creditworthiness and drafts the letter of credit based on the sales agreement.
- The exporter’s bank receives and approves the letter before forwarding it to the exporter.
- The exporter ships goods and provides necessary documentation.
- Compliance checks by banks ensure terms are met, and the importer’s bank finally sends payment.
- The importer can then claim the shipped goods.
Advantages and Disadvantages of a Letter of Credit
Advantages
- Enhances security and trust among transaction parties.
- Clearly defines transaction specifics.
- Tailors transaction terms to specific needs.
- Facilitates efficient funds transfer.
Disadvantages
- Buyers bear the costs.
- May miss intricate transaction details.
- Could be time-consuming to establish.
- May not adapt to unexpected political/economic shifts.
The Bottom Line
Letters of credit are an essential tool in the international trade toolkit, offering security to both buyers and sellers. They come in various types suited to different circumstances and ensure smoother transactions. Banks, particularly larger institutions, are the starting point for leveraging this financial instrument.
Related Terms: Negotiable Instrument, Commercial Letter of Credit, Standby Letter of Credit.
References
- International Trade Administration. “What Is a Letter of Credit?”
- International Chamber of Commerce. “Global Rules”.
- Export-Import Bank of the United States. “To Confirm or Not to Confirm (Letters of Credit)”.
- Cornell Law School. “12 CFR § 208.24 - Letters of credit and acceptances.”
- USAID. “Letters of Credit and Trade Finance”, p.106.
- FDIC. “Off-Balance Sheet Activities”, p.2
- Columbia Bank. “Letters of Credit.”
- Citi. “International Trade”.
- Citi. “Products and Services”.
- International Trade Administration. “Letter of Credit.”
- International Trade Administration. “Trade Finance Guide”, Page 7.
