Letter_of_credit

What Is a Letter of Credit?

A letter of credit (LC) is a financial instrument, typically issued by a bank, that guarantees payment to a seller (beneficiary) on behalf of a buyer (applicant), provided the seller meets specific conditions outlined in the document. This mechanism falls under the broader category of trade finance and is a cornerstone of international trade, where parties often operate across vast distances and may lack established trust. A letter of credit essentially substitutes the creditworthiness of the buyer with that of the issuing bank, significantly reducing the risk for the seller.

History and Origin

The concept of a letter of credit dates back to ancient civilizations, where early forms facilitated long-distance trade by establishing trust-based systems among merchants. As trade networks expanded through the Middle Ages, European merchants and bankers refined these practices.²⁹ The modern letter of credit evolved significantly to support complex global commerce, providing a secure payment mechanism. Its widespread adoption led to the development of standardized rules. The International Chamber of Commerce (ICC) first issued the Uniform Customs and Practice for Documentary Credits (UCP) in 1933, creating a voluntary framework that governs letter of credit transactions worldwide.²⁸ The latest version, UCP 600, came into effect in 2007 and serves as the primary international standard.²⁶, ²⁷

Key Takeaways

• A letter of credit guarantees payment from a bank to a seller upon fulfillment of specified conditions.
• It primarily mitigates payment risk in international trade, benefiting both buyers and sellers.
• The International Chamber of Commerce's UCP 600 provides the globally accepted rules for letter of credit transactions.
• The issuing bank's obligation to pay is independent of the underlying sales contract, relying solely on the presented documents.
• Various types of letters of credit exist, each designed for specific trade scenarios and risk management.

Formula and Calculation

A letter of credit does not involve a specific financial formula or calculation in the traditional sense, as it is a guarantee instrument rather than a direct calculation of value or return. However, banks involved in a letter of credit transaction will calculate fees and charges. These typically include:

• Issuance Fee: A percentage of the letter of credit's value, or a flat fee.
• Advising Fee: Paid to the advising bank for notifying the beneficiary.
• Confirmation Fee (if applicable): Paid to the confirming bank for adding its guarantee.
• Negotiation/Discrepancy Fees: Charges for processing documents, especially if discrepancies arise.

The total cost to the applicant will be the sum of these fees. For example, if a letter of credit is issued for $100,000 with an issuance fee of 0.5%, the issuance fee would be $500. Other fees would be added based on the services rendered by various financial institutions.

Interpreting the Letter of Credit

Interpreting a letter of credit involves a meticulous review of its terms and conditions, as the bank's obligation to pay is strictly based on the documents presented, not the actual goods or services. The core principle is that the letter of credit is independent of the underlying sales contract.²⁵ This means the bank deals in documents, not in goods. Key elements to interpret include:

• Applicant and Beneficiary: Identifying who the buyer (applicant) and seller (beneficiary) are.
• Issuing Bank and Advising/Confirming Bank: Understanding the roles and responsibilities of each bank involved.
• Amount and Currency: The maximum amount payable and the currency of payment.
• Expiration Date: The last day on which documents can be presented for payment.
• Documents Required: A precise list of documents (e.g., bill of lading, commercial invoice, packing list, certificate of origin, insurance policy) that the beneficiary must present.
• Description of Goods/Services: A brief description that must match the commercial invoice.
• Shipment Details: Conditions related to the shipment, such as loading port, discharge port, and latest shipment date.

Any deviation in the presented documents from the terms of the letter of credit is considered a discrepancy, which can lead to delayed payment or non-payment.

Hypothetical Example

Consider an electronics manufacturer, "TechGlobal Inc." (seller/beneficiary) in Germany, selling specialized machinery worth $500,000 to "Innovate Solutions Ltd." (buyer/applicant) in Brazil. Due to the international distance and lack of established business history, Innovate Solutions' bank, "Bank of Brazil," issues a letter of credit in favor of TechGlobal Inc.

The letter of credit specifies that Bank of Brazil will pay TechGlobal Inc. $500,000 upon presentation of the following documents:

1. Commercial Invoice for $500,000.
2. Bill of Lading indicating shipment of machinery from Hamburg to Rio de Janeiro.
3. Packing List.
4. Certificate of Inspection from an independent third party.

Upon receiving the letter of credit, TechGlobal Inc. manufactures and ships the machinery. They then obtain all the required documents and present them to their local bank, "Deutsche Bank" (the advising bank). Deutsche Bank verifies the documents against the letter of credit terms. If all documents are compliant, Deutsche Bank forwards them to Bank of Brazil. Bank of Brazil, upon confirming document compliance, releases the $500,000 payment to Deutsche Bank, which then credits TechGlobal Inc.'s account. This ensures TechGlobal Inc. receives payment as long as they meet the stipulated conditions, and Innovate Solutions Ltd. receives the goods once payment is assured. This process reduces the payment risk for both parties and facilitates the cross-border transaction.

Practical Applications

Letters of credit are indispensable in numerous real-world financial and trade scenarios, particularly in international trade. They are commonly used when:

• New Trading Relationships: A buyer and seller are engaging in trade for the first time and trust has not yet been established.
• High-Value Transactions: The value of the goods or services being exchanged is substantial, making payment assurance critical.
• Countries with Political or Economic Instability: Trading with entities in regions where there is a higher risk of payment default or transfer restrictions.
• Import/Export Financing: Export-Import Banks, such as the Export-Import Bank of the United States (EXIM Bank) or similar institutions in other countries, often use or require letters of credit as part of their trade finance products to support domestic exporters.²⁴
• Project Finance: In large infrastructure or construction projects, a letter of credit can guarantee payment milestones or completion bonds.

They are a crucial component of supply chain finance and risk management strategies for businesses involved in global commerce, enabling smoother and more secure transactions across diverse legal and economic environments.

Limitations and Criticisms

While highly effective, letters of credit have limitations and criticisms. A primary concern is the "documentary nature" of the instrument. Since banks deal only with documents, not the physical goods, discrepancies in paperwork, even minor ones, can lead to payment delays or refusal. This can create friction between the parties, despite the underlying trade being perfectly executed. The complexity of adhering strictly to UCP 600 rules can also be a challenge, particularly for less experienced parties.

Another critique arises from the potential for fraud. Although a letter of credit reduces credit risk, it does not eliminate the risk of fraud related to the underlying transaction, such as forged documents or non-conforming goods being shipped. For instance, there have been cases where sophisticated criminal networks attempt to defraud parties by presenting falsified documents against legitimate letters of credit. Law enforcement agencies and financial institutions globally continue to combat such schemes.²², ²³

Furthermore, the cost associated with letters of credit, including bank fees, can be higher than other payment methods, especially for smaller transactions. The process can also be time-consuming, requiring multiple steps and document verification, which may not suit fast-paced trade environments. Despite these drawbacks, for situations demanding strong payment assurance, the benefits of a letter of credit often outweigh the complexities and costs, especially in high-value or high-risk international dealings. Parties must carefully consider the trade-off between security and efficiency.

Letter of Credit vs. Bank Guarantee

While both a letter of credit and a bank guarantee are banking instruments that provide payment assurance, they differ fundamentally in their purpose and trigger for payment.

In essence, a letter of credit is a payment mechanism, whereas a bank guarantee is a contingent liability that acts as a safety net against non-performance. A letter of credit ensures payment will occur if conditions are met, while a bank guarantee ensures payment if a default occurs.

FAQs

What are the main types of letters of credit?

There are several types, including:

• Revocable vs. Irrevocable: An irrevocable letter of credit cannot be amended or canceled without the agreement of all parties, offering more security to the beneficiary.
• Confirmed vs. Unconfirmed: A confirmed letter of credit has a second bank (the confirming bank) add its guarantee of payment, further reducing risk, especially in high-risk regions or for unknown issuing banks.
• Sight vs. Usance: A sight letter of credit means payment is due immediately upon presentation of compliant documents, while a usance (or time) letter of credit allows for payment at a future date, such as 30 or 60 days after presentation.
• Transferable: Allows the beneficiary to transfer all or part of the letter of credit to one or more third parties, often used by intermediaries or trading houses.
  These variations allow flexibility to tailor the letter of credit to specific trade terms and risk appetites.

What is the role of the advising bank in a letter of credit transaction?

The advising bank, typically located in the beneficiary's country, authenticates the letter of credit issued by the opening bank and informs the beneficiary of its terms. It acts as a conduit for documents and payments but does not undertake any payment obligation unless it also confirms the letter of credit. Its primary role is to ensure the genuineness of the letter of credit and convey it accurately to the beneficiary.

Can a letter of credit be canceled?

An irrevocable letter of credit cannot be canceled or amended without the consent of the issuing bank, the confirming bank (if any), and the beneficiary. This provides significant assurance to the seller. Revocable letters of credit, which are rare in international trade, can be amended or canceled by the issuing bank without prior notice to the beneficiary. Due to the lack of security, revocable letters of credit are seldom used in commercial transactions.

What happens if documents presented against a letter of credit contain discrepancies?

If the documents presented by the beneficiary do not strictly comply with the terms and conditions of the letter of credit, they are considered discrepant. The issuing bank or nominated bank can refuse to honor the presentation. The beneficiary will then be notified of the discrepancies and usually given an opportunity to correct them if time permits. Alternatively, the bank may seek a waiver from the applicant, asking them to accept the discrepancies. If the discrepancies are not resolved or waived, the bank is not obligated to pay. This highlights the importance of precise document preparation in documentary credit transactions.

How does a letter of credit benefit the buyer?

For the buyer (applicant), a letter of credit provides assurance that the seller will only be paid once the specified conditions, typically related to shipment and documentation, are met. This protects the buyer from paying for goods that are never shipped or do not conform to the agreed-upon terms, thus mitigating their performance risk. It also enables them to engage in trade with new or distant suppliers with greater confidence.¹, ²³, ⁴, ⁵, ⁶⁷⁸, ^9101112, ¹³¹⁴, ¹⁵, ¹⁶[¹⁷](https://digitalcommons.law.umaryland.edu/cgi/viewcontent.cgi?params=/context/mlr/article/[¹⁸](https://www.iccindonesia.org/ucp-600/), ¹⁹2619/&path_info=45_2_432_letters.pdf)