Payment is the most dangerous point of any foreign transaction; the seller fears sending the goods and not receiving the money, and the buyer fears paying and not seeing the goods. The Letter of Credit (LC) is designed exactly to solve this problem. In this article we explain the LC simply and practically for the import and export trade.
What is a Letter of Credit?
A Letter of Credit is a bank commitment in which the buyer’s bank (the issuing bank) guarantees to pay the seller the amount in exchange for the presentation of the complete documents that comply with the agreed conditions. In simple words, the bank, as the intermediary, reduces the risk of both parties.
Note: the Letter of Credit is one of the options of the international payment methods. For large amounts and unknown sellers, the LC is the safest choice.
The main elements of a Letter of Credit
An LC usually includes these parts:
- The parties: namely the buyer, the seller and the banks involved
- The amount and the currency: the payable amount and the currency of the transaction
- The required documents: invoice, packing list, waybill, insurance and the related certificates
- The delivery condition (Incoterms): the responsibility of the transport and the insurance (details in the Incoterms 2020 guide)
- The expiry date and the deadline for presenting the documents
The common types of Letter of Credit
| Type | Feature | Suitable for |
|---|---|---|
| Revocable LC | the bank can cancel it | rarely recommended |
| Irrevocable LC | not cancelled without the seller’s consent | standard and safe |
| Confirmed LC | confirmed by a second bank | reduces the risk of a weak bank |
| Sight LC | the payment with the presentation of the documents | common for the clearance of goods |
The steps of opening and using an LC
- Agreeing the conditions: the buyer and the seller agree on the conditions (amount, documents, date).
- Opening the credit: the buyer asks his bank to open the LC.
- Notifying the seller: the seller’s bank notifies the LC.
- Transporting the goods and issuing the documents: the seller transports the goods and prepares the documents.
- Presenting the documents and receiving the payment: with the full matching of the documents, the bank pays.
An important note
Any discrepancy between the documents and the LC conditions can delay the payment. For a fault-free clearance, know how to fill the customs declaration and prepare the documents accurately in accordance with the bank conditions.
The Letter of Credit and the cost of the documents
The cost of opening and presenting the documents is usually a small percentage of the amount and depends on the issuing bank. For an accurate calculation, consider this cost as part of the landed cost of the goods.
FAQ
How safe is the LC compared to a prepayment?
Much safer; the bank gives the payment guarantee in exchange for the complete documents and reduces the fraud risk. The comparison details are in the international payment methods.
Do we also have an LC for the overland transport?
Yes. The difference is in the documents; in the overland transport, the CMR is used instead of the sea waybill.
Which LC type should I choose?
For common trade and an agreement with an unknown seller, the irrevocable LC and, in the case of a high cost, with the confirmation of a second bank (confirmed) is the best option.
Is the LC related to the cargo insurance?
Yes; the LC conditions usually require the presentation of the reality insurance.
Summary
The Letter of Credit, with the role of the bank, significantly reduces the payment risk in international trade. By choosing the right type, preparing the accurate documents and coordinating with the bank, you carry out large transactions with more security. The Vira Farabar Logistics experts help you in preparing the transport documents to comply with the LC conditions.
