Letter of Credit (LC) is a financial instrument provided by a third party, usually a financial institution such as a bank, which guarantees payment to a seller on behalf of a buyer. They are commonly used in international trade to ensure timely and full payment to the seller, and if the buyer is unable to make such a payment, the bank covers the full or remaining amount on behalf of the buyer.
SWIFT Code
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) network plays a crucial role in facilitating these transactions. SWIFT provides a standardized and secure system for sending and receiving financial messages, including those related to LCs, between banks and financial institutions globally.
Each bank involved in the SWIFT network has a unique SWIFT code, also known as a Bank Identifier Code (BIC), which ensures accurate and secure communication.
The Importance of Timely Payments
Timely payments are crucial for businesses, whether dealing with local or global customers. While a handshake or contract might suffice for some transactions, a letter of credit offers a more reliable and secure option. This is especially vital for businesses involved in international trade, imports, or exports, where payment assurance is crucial.
How a Letter of Credit Works
A letter of credit begins when two parties have a transactional need. One party requests a letter of credit to be provided to the receiving party. Since a bank or financial institution issues the letter of credit, it holds more weight than a simple agreement between two parties.
When to Use a Letter of Credit
Letters of credit are particularly important in international trade. They help importers and exporters make deals with greater security and comfort, as the issuing bank guarantees the payment component of their transaction.
Benefits and Limitations of a Letter of Credit
Letters of credit guarantee payment to buyers and sellers in many situations, both domestic and international. They ensure smooth payments in deals with complex details, such as international laws. Additionally, they help build and strengthen relationships between new vendors starting to do business together.
Types of Letters of Credit
There are several types of letters of credit, each with unique benefits and considerations. Some are more common, while others suit specific scenarios. The main types include:
Transferable, Untransferable, Confirmed, Unconfirmed, Effective, Non-Effective, Revocable, Irrevocable, Sight, Deferred, Revolving, Commercial, and Standby letters of credit.
Key Definitions
Commercial letter of credit: Used in commercial transactions, often in international trade. The bank makes a direct payment to the beneficiary.
Revolving letter of credit: Allows multiple draws within a limit during a set period. Useful for frequent shipments without redrafting the letter.
Confirmed letter of credit: Involves a second bank, typically the seller’s bank, guaranteeing the letter. Ensures payment if the holder and issuing bank defaults.
Standby letter of credit: Provides payment if something doesn’t occur, similar to an insurance contract. Protects the beneficiary if the other party fails to perform duties.
Irrevocable LC: Cannot be canceled or modified without the beneficiary’s consent. Reflects the bank’s absolute liability.
Revocable LC: Can be canceled or modified by the bank without the beneficiary’s consent. The bank has no liability after revocation.
Transferable LC: Allows the seller to assign part of the letter to another party. Useful when the seller isn’t the sole manufacturer.
Back-to-Back LC: Issues a second LC based on the first. Opened in favor of an intermediary and then a new LC in favor of the goods’ seller.
Sight LC: Payment is made immediately (within 7 days) after submitting the required documents.
Deferred Payment LC: Payment is made at a later date, not when documents are submitted.
Effective and Non-Effective Letters of Credit
Effective letter of credit: Irrevocable, providing high security for both parties. Guarantees payment if the seller fulfills obligations. It can be confirmed or unconfirmed.
Non-Effective letter of credit: Revocable, allowing modification or cancellation without beneficiary consent. It is less secure, rarely used, and not covered by UCP600.
Discounting an L/C
Discounting an L/C lets the bank pay the beneficiary before maturity. It provides immediate funds but transfers the risk of non-payment to the bank.
You may find here an Application Form for a Letter of Credit.
