A letter of credit is a financial guarantee provided by a bank or lender that ensures a seller receives payment from a buyer on time and for the agreed amount. Commonly used in international trade, it bridges the trust gap between buyers and sellers who may not have an established business relationship. This tool offers security to both parties, making cross-border transactions smoother and more reliable.
How does a letter of credit work?
In international trade, sellers face the risk of non-payment, while buyers worry about not receiving their goods. A letter of credit addresses these concerns by involving a trusted third party—a bank or financial institution.
Here’s how it works:
- Buyer’s request: The buyer requests a letter of credit from their bank.
- Bank guarantee: The bank guarantees payment to the seller, provided all terms and conditions of the transaction are met.
- Proof of shipment: The seller provides documents, such as proof of shipping, to demonstrate they’ve fulfilled their obligations.
- Payment release: Once the bank verifies the documents, payment is made to the seller.
When is a letter of credit used?
Letters of credit are typically used in international trade, where the buyer and seller may be in different countries with varying regulations and business practices. They’re particularly useful when:
- There’s a time gap between the dispatch and delivery of goods.
- The seller wants assurance of payment before shipping.
- The buyer wants confirmation that goods will be delivered before making payment.
Additionally, some trade finance and import/export finance agreements may require a letter of credit to guarantee repayment to the funder.
Costs of a letter of credit
Banks or lenders charge a fee for issuing a letter of credit, usually calculated as a percentage of the amount covered. For example, if the fee is 1% and the letter covers £100,000, the fee would be £1,000. It’s important to consider these costs when deciding whether a letter of credit is the right solution for your business.
Types of letters of credit
Letters of credit come in various forms to suit different needs:
- Irrevocable: Cannot be cancelled or altered without the consent of all parties, providing greater security.
- Revocable: Can be modified or cancelled by the issuing bank without prior notice, offering less security.
- Confirmed: A second bank confirms the letter, providing additional assurance to the seller.
- Unconfirmed: Only the issuing bank guarantees the payment.
- Transferable: Allows the seller to transfer the payment guarantee to another party, often used when intermediaries are involved.
Other variations include:
- Standby: Used as a backup, providing security if the buyer defaults.
- Revolving: Covers multiple transactions over a set period, ideal for ongoing trade relationships.
- Back-to-back: Involves intermediaries and ensures all parties in the chain are covered.
Benefits of a letter of credit
For sellers
- Payment security: Ensures that payment will be made on time and in full.
- Reduced risk: The bank assumes the buyer’s credit risk.
- Enhanced financing options: Trade finance providers may require a letter of credit before finalising a facility, allowing sellers to secure the materials needed to fulfill orders.
For buyers
- Delivery assurance: Guarantees that goods will be received before payment is made.
- Improved trust: Facilitates smoother transactions with international sellers.
What is UCP 600?
UCP 600, or Uniform Customs and Practice for Documentary Credits, is a set of globally recognised rules governing the use of letters of credit. Established by the International Chamber of Commerce, these standards ensure consistency and reliability in international trade. While businesses don’t need to know every detail, it’s reassuring to know that such guidelines exist.
Is a letter of credit right for your business?
If your business frequently trades internationally or deals with unfamiliar suppliers, a letter of credit can provide the security needed to minimise risks. While it comes at a cost, the peace of mind it offers to both buyers and sellers often outweighs the expense.
To explore whether a letter of credit suits your trade needs, consider consulting a trade finance expert who can guide you through the process and help you assess your options.