Letter of Credit (LC): Meaning, Use, Process, Types, Cost, Benefits and Risks in International Trade

The biggest challenge in international trade is payment security. When exporter and importer are located in different countries, it becomes difficult to build trust. The exporter is at a risk whether he will receive the payment after sending the goods or not and the importer is at a risk whether the goods will be received in the right quality after making the payment.

To solve this problem, Letter of Credit (LC) is used. LC is an important financial instrument of international trade which provides protection to both buyer and seller. LC issued through banks ensures that payment will be received only if the seller submits the required documents.

In this blog we will discuss in detail Letter of Credit meaning, process, types, cost, benefits and risks, so that you can get complete understanding of LC system.

1. What is a Letter of Credit (LC)?

Letter of Credit (LC) is a financial document which is issued by the buyer's bank and gives payment guarantee to the seller. If the seller submits the conditions and documents mentioned in the LC, the bank makes the payment on behalf of the buyer.

In simple words, Letter of Credit is a bank guarantee that makes international trade transactions secure. For example, if an exporter from India sells goods to an importer from Germany, the importer's bank issues an LC to the exporter. This means that if the exporter submits the shipping documents the bank will release the payment.

For this reason, Letter of Credit is considered one of the most secure payment methods in international trade.

2. Why is a Letter of Credit (LC) Used?

In international trade, distance and legal differences exist between buyer and seller. Because of this there is risk in direct payment.

Main reasons for using Letter of Credit:

• Exporter gets payment security
• Importer gets assurance that payment will be made after the goods are shipped
• Monitors bank transactions
• The risk of trade disputes appears to be reducing.

Letter of Credit (LC) system builds trust and makes large value international trade deals safe. That is why LC payment method is widely used in export import business.

3. Importance of Letter of Credit (LC)

Letter of Credit (LC) has great importance in global trade. It provides a trusted payment mechanism that enables international transactions to be executed smoothly. LC system operates through banks, so both buyer and seller get financial security. This tab is especially important when the exporter and importer are doing business for the first time.

Letter of Credit is considered the most reliable option for international trade payment method in large shipments, high value goods and long distance trade.

4. Facilitates International Trade

Letter of Credit promotes international trade. When payment is secure, exporters and importers can do business confidently. LC system also helps small and medium exporters to enter the global market. Through this it becomes possible to trade with buyers also. Due to this reason, Letter of Credit (LC) has become an important tool of global trade financing.

5. How Does a Letter of Credit (LC) Work?

The process of Letter of Credit (LC) is completed in multiple steps. Banks and documents have played an important role in this process.

The LC process generally works this way:

A. Buyer and Seller Agreement

The first step of the Letter of Credit process is the trade agreement between the buyer and the seller. Importer and exporter sign a sales contract or purchase agreement in which product details, quantity, price , delivery terms and payment method are clearly mentioned. If both parties want secure payment then Letter of Credit (LC) payment method is decided in the contract. In this agreement LC type, shipment date and required documents are also specified so that there is no dispute in future.

B. Letter of Credit (LC) Application

After the agreement is finalized, the importer submits an application to his bank to issue Letter of Credit. In this process the buyer gives some important documents to the bank like proforma invoice, purchase contract and shipment details. The bank verifies the financial position and creditworthiness of the importer. If the bank is satisfied then it gives approval to issue the LC.

C. Issuing Bank issues

Importer's bank, which is called Issuing Bank, officially creates the Letter of Credit. In this LC document payment amount, shipment deadline, required documents and payment conditions are mentioned. The issuing bank then sends this LC to the exporter's bank which is called Advising Bank. The advising bank informs the exporter that the LC has been opened from the buyer's side and now the shipment process can be started.

D. Seller ships the goods

When the exporter receives the LC and checks its conditions and everything is correct, then he arranges the goods shipment. Exporter packs the products and sends them to the buyer's country through the shipping company. After shipment, the exporter receives some important documents like Bill of Lading, Commercial Invoice, Packing List and Insurance documents, which are required for the LC payment process.

E. Documents have to be submitted to the Bank

After shipping the goods, the exporter submits all the documents required in LC to his bank. These documents are proof that the exporter has completed the shipment as per the contract. The Bank checks the documents carefully to ensure that all the details are as per the Letter of Credit terms and conditions.

F. Bank Verification and Payment Release

In the final step the bank verifies the submitted documents. If the documents match the conditions mentioned in the LC, the bank releases the payment to the exporter. The issuing bank recovers the payment from the buyer and the transaction is completed.

Due to this process, the Letter of Credit international trade payment system is considered secure and reliable.

6. Types of Letter of Credit (LC)

Different types of Letter of Credit (LC) are used according to different situations in international trade.

Revocable Letter of Credit

Revocable Letter of Credit is such an LC which the issuing bank or the buyer can modify or cancel at any time and for this it is not necessary to take the permission of the seller. Due to this, this payment method is not considered secure for the exporter. In today's time, its use in international trade has reduced a lot because sellers usually prefer irrevocable LC which has more payment security.

Irrevocable Letter of Credit

Irrevocable Letter of Credit is the most commonly used LC in international trade. This type of LC cannot be canceled or modified by the issuing bank, buyer or any party without the consent of the seller. This gives strong payment security to the exporter. If the seller submits the conditions and documents mentioned in the LC the bank is legally bound to release the payment.

Sight letter of credit

Payment in Sight Letter of Credit is released immediately when the exporter submits the required documents to the bank and the bank verifies them. This means that the exporter gets the payment soon after the shipment. This LC is used in transactions where the seller wants quick payment and the buyer also prefers fast transaction.

Confirmed Letter of Credit

In Confirmed Letter of Credit, apart from the issuing bank, another bank also provides payment guarantee. This additional bank is called confirming bank. This system tab is used when the exporter does not have full trust on the financial system of the buyer's bank or the buyer's country. Confirmed LC provides extra security for the exporter.

Transferable Letter of Credit

In Transferable Letter of Credit the original beneficiary (seller) can transfer part or the entire amount of LC to another supplier. This type of LC is useful for trading companies and intermediaries who do not manufacture the goods themselves but purchase from suppliers and sell them to buyers.

Standby Letter of Credit

Standby Letter of Credit is a backup payment guarantee that is activated if the buyer does not fulfill his payment obligation. If importer fails to make payment then exporter can claim LC through bank. That is why standby LC is also called a kind of financial safety net.

Back-to-Back Letter of Credit

Back-to-Back Letter of Credit is usually used in transactions of traders and middlemen. In this, on the basis of one LC, another LC is opened. The first LC comes from the buyer's bank and against it the trader opens the second LC for his supplier. This system helps in managing supply chain transactions.

Commercial letter of credit

Commercial Letter of Credit is issued for normal trade transactions and is also called documentary letter of credit. There is a payment tab when the exporter submits the shipping documents to the bank and they match the LC conditions. These LCs are widely used in international export-import business.

Acceptance or timed letter of credit

Payment in Acceptance or Usance Letter of Credit is not made immediately but is released after a fixed time period. For example 30 days, 60 days or 90 days after shipment. This type of LC provides credit period to the buyer and the exporter gets assured payment on future date.

Restricted letter of credit

In Restricted Letter of Credit the exporter has to receive payment only through a specific bank. It is clearly mentioned in the LC that the documents and payment processing will be done from a particular bank. This is issued for the purpose of control and monitoring.

Revolving letter of credit

Revolving Letter of Credit is used in long-term business relationships where there are regular shipments between buyer and seller. In this LC, the credit limit is automatically renewed after onetime payment, hence there is no need to open a new LC for every shipment. This system makes continuous trade transactions easy and efficient.

7. Documents Required for a Letter of Credit (LC)

To open or apply for Letter of Credit (LC), the importer has to submit some important documents to his bank. The bank verifies these documents to ensure that the trade transaction is genuine and the buyer can fulfill the payment obligation.

Common documents required for Letter of Credit application include:

• KYC documents
• Proforma Invoice issued by the exporter
• Purchase Order or Sales Contract
• Impor Export Code (IEC) of the importer
• Packing, shipping and transport documents
• Company registration documents
• Bank account details and financial documents
• Import license (if required for specific products)
• Any other document required by the lender

8. Cost of Letter of Credit (LC)

Banks charge some charges for issuing Letter of Credit. These charges vary according to trade value and bank policies.

Common LC charges include:

• LC opening charges
• LC amendment charges
• Document handling charges
• Confirmation charges
• Negotiation charges

Generally LC cost ranges from 0.5% to 2% of the transaction value. This cost is considered normal in large value international trade deals.

9. How to Apply for a Letter of Credit (LC)?

To apply for Letter of Credit (LC), the importer has to submit a request to his bank. The bank checks the financial position and trade details of the importer, after which LC is issued.

The following steps are included in the application process:

Importer fills the LC application form in the bank – In this form the buyer has to give product details, LC amount, shipment date and exporter information.

Submit trade agreement and proforma invoice – These documents help the bank to verify the authenticity of the transaction.

Bank verifies creditworthiness of buyer –Bank checks financial capacity, banking history and account details of importer.

Bank issues LC – After verification is complete, the bank issues Letter of Credit in favor of the exporter in which payment terms and conditions are mentioned.

LC is sent to the exporter's bank – The issuing bank forwards the LC to the exporter's bank (Advising Bank), which informs the exporter that the LC has been received.

This complete procedure is called LC issuance process, which makes international trade transactions secure.

10. Advantages & Disadvantages of Letter of Credit (LC)

Advantages of Letter of Credit

• Exporter gets secure payment
• Importer gets shipment assurance
• International trade risk has reduced
• Bank transactions monitor
• Global trade facility is available

Disadvantages of Letter of Credit

• Bank charges may be high
• Documentation process is complex
• It may be difficult for small exporters
• Processing may take time

Letter of Credit is considered one of the most trusted international trade payment methods.

Frequently Asked Questions (FAQs)

1. What is a Letter of Credit (LC) in international trade?

Letter of Credit (LC) is a financial document which the buyer's bank issues and gives payment guarantee to the exporter. If the exporter submits the conditions mentioned in the LC and submits the required documents, the bank releases the payment from the buyer's side.

2. Why is Letter of Credit important in export-import business?

Letter of Credit provides payment security in international trade. With this, the exporter gets assured payment and the importer gets the assurance that payment will be made only when the goods shipment documents are submitted.

3. Who issues a Letter of Credit?

Letter of Credit is issued by the buyer's bank which is called Issuing Bank. This bank opens LC in favor of the exporter and provides payment guarantee.

4. Which documents are required to open a Letter of Credit?

To open LC, importer has to submit some documents to the bank like Proforma Invoice, Purchase Order, IEC (Importer Exporter Code), KYC documents, company registration details and financial documents.

5. What are the main types of Letter of Credit?

Commonly used LC types in international trade include Irrevocable LC, Sight LC, Confirmed LC, Transferable LC, Standby LC, Back-to-Back LC and Revolving LC.

6. What is the difference between Sight LC and Usance LC?

In Sight LC, payment is released immediately after the documents are verified, whereas in Usance (Acceptance) LC, payment is made after a fixed credit period like 30, 60 or 90 days.

7. Is Letter of Credit safe for exporters?

Well, Letter of Credit is considered a safe payment method for exporters because the bank gives payment guarantee, only the exporter has to submit the documents according to the LC conditions.

8. Can a Letter of Credit be cancelled?

If LC is revocable then issuing bank or buyer can cancel it. But irrevocable LC cannot be canceled or modified without the consent of the seller.

Conclusion:

Trust and payment security are the most important factors in international trade. Letter of Credit system provides protection to both buyer and seller and makes transactions through banks secure. If the exporter submits the required documents, the bank guarantees the payment, thereby eliminating the payment risk to a large extent. For this reason, Letter of Credit (LC) international trade payment method is widely used in global trade and is considered a reliable financial instrument for exporters and importers.