Letter Of Credit

A letter of credit is a formal document issued by a bank on behalf of a buyer, guaranteeing payment to a seller upon the fulfillment of specific terms. This instrument is especially vital in international trade, where the parties may not know each other personally and where differences in law and distance increase the need for transactional assurance. An interesting fact is that letters of credit have significantly reduced the risk of non-payment in global commerce, shaping the way companies conduct business across borders.

What is Letter of Credit?

A letter of credit is a binding commitment from a buyer’s financial institution to pay the seller a designated sum once certain conditions, usually delivery of goods and submission of required documents, are met. Consider a UK importer purchasing electronics from a supplier in Japan. The Japanese supplier wants certainty of payment before shipping large orders. The UK buyer's bank issues a letter of credit; once the supplier provides proof of shipment and other required papers, the bank remits payment as agreed. This method gives both sides security: the supplier receives guaranteed payment, and the buyer ensures goods are shipped as promised.

How Letters of Credit Work in International Trade

In a typical invoice factoring arrangement, risk is transferred from the exporter and importer to their respective financial institutions. The process starts when the buyer arranges a letter of credit with their bank, specifying the payment amount, timeframe, documents required, and shipment details. After the seller ships the goods and presents proper documentation, the buyer's bank examines the papers. If they precisely conform to terms listed in the letter of credit, the bank pays the seller. Only after this does the buyer’s account get debited or the loan repaid.

Types of Letters of Credit

There are several types of letters of credit suited to different needs. A revocable letter of credit allows the buyer or bank to adjust or cancel terms without the seller’s consent until documents are presented, but this is rare due to the lack of certainty for the seller. In contrast, irrevocable letters of credit, which cannot be changed without all parties’ agreement, are standard in international trade. Then there are standby letters of credit, mainly used as backup assurance for payment obligations, and confirmed letters of credit, where a second bank (often in the exporter’s country) adds its own guarantee to the payment.

Example Calculation: Confirmed Letter of Credit with Bank Charges

Suppose a UK-based importer wants to purchase machinery worth £50,000 from an overseas supplier. The supplier requires a confirmed irrevocable letter of credit. The buyer's bank agrees to open a letter of credit for the full amount. The bank charges a 1% fee for the service:

Calculation:

Letter of credit amount: £50,000
Bank fee: 1% of £50,000 = £500
Total cost to the importer: £50,000 + £500 = £50,500

Once the supplier provides the necessary shipping documents, the bank pays the £50,000. The fee covers the bank’s risk, document review, and administrative efforts.

Historical Background and Evolution

Letters of credit can be traced back centuries, evolving to facilitate international commerce. Historically, trade between distant regions required a trustworthy system to ensure payment security. Letters of credit became ubiquitous in the 20th century with the expansion of global trade, supported by international conventions like the Uniform Customs and Practice for Documentary Credits (UCP), which standardised rules and documentation requirements worldwide.

Pros and Cons of Using Letters of Credit

There are clear educational advantages to using letters of credit. For sellers, the principal benefit is protection against non-payment. Buyers can access a broader range of suppliers and may negotiate more favourable purchase terms by providing security. However, these instruments can entail considerable costs, requiring fees for issuance, confirmation, and document examination, and may involve complex paperwork. Delays or discrepancies in documents may postpone payments or even void the guarantee, leading to disputes. Therefore, both parties need to ensure every detail in the letter of credit is accurately met, or risk complications with receiving or making payments.

Key Considerations and Practical Uses

Modern collateral-backed trade finance relies heavily on letters of credit. They help bridge the trust gap in transactions involving new trading partners, high-value goods, or unfamiliar jurisdictions. Businesses frequently use letters of credit when exporting or importing cars, electronics, textiles, or commodity products. It’s crucial for both exporters and importers to work closely with banks and understand the specific terms and timelines attached to their letters of credit.

By gaining a clear understanding of letters of credit, UK businesses can access new markets with greater confidence. For those seeking further support on trade finance or working capital options, exploring business funding solutions can provide valuable tools and advice tailored to the evolving needs of global commerce.