Introduction: What is a Letter of Credit?
In international trade, transactions between buyers and sellers often involve financial risks due to geographical and legal differences. A Letter of Credit (LC) is a widely used financial instrument that ensures secure payments and builds trust between buyer and seller.
Table of Contents
1. What is a Letter of Credit (LC)?
A Letter of Credit (LC) is a financial guarantee issued by a bank that ensures the seller (exporter) gets paid after all the required trade documents are presented. Letter of credit play role as a bridge of trust between the buyer and seller in international trade(export & import).
Key Participants in an LC Transaction:
- Applicant (Buyer) – The party requesting the LC from their bank.
- Issuing Bank – The bank that issues the LC on behalf of the buyer.
- Beneficiary (Seller) – The party receiving the payment.
- Advising Bank – The bank in the seller’s country that confirms the LC.
- Negotiating Bank – The bank that verifies and processes the documents.
- Confirming Bank – (Optional) A third-party bank that guarantees payment.
2. How Does a Letter of Credit Work?
Step-by-Step LC Process:
📌 Step 1: Buyer & seller agree on LC payment terms.
📌 Step 2: Buyer applies for an LC from their bank.
📌 Step 3: Issuing bank sends the LC to the seller’s bank (advising bank).
📌 Step 4: Seller ships goods & submits documents to their bank.
📌 Step 5: Advising bank verifies documents and forwards them to the issuing bank.
📌 Step 6: If documents are correct, the bank releases payment to the seller.
📌 Step 7: Buyer receives goods & settles payment with their bank.
3. Types of Letter of Credit
A. Based on Payment Conditions
- Sight LC: Payment is made immediately once documents are verified.
- Usance (Deferred) LC: Payment is made after a credit period (30, 60, or 90 days).
B. Based on Guarantee
- Confirmed LC: A second bank guarantees payment if the issuing bank defaults.
- Unconfirmed LC: No additional bank guarantees the payment.
C. Based on Flexibility
- Revocable LC: Can be changed or canceled without seller’s consent. (Rarely used)
- Irrevocable LC: Cannot be modified without mutual agreement. (Most common)
D. Based on Trade Needs
- Standby LC: Used as a financial backup if the buyer fails to pay.
- Transferable LC: Beneficiary can transfer LC rights to another party (used in middleman transactions).
- Back-to-Back LC: Two linked LCs used when an intermediary is involved.
- Red Clause LC: Seller receives an advance before shipping goods.
- Green Clause LC: Includes advance for storage & insurance costs.
📊 Graph: Global Usage of Different Types of LC in Trade Finance (2023)
(Data Source: ICC Trade Finance Survey)
4. Benefits & Risks of Using an LC
✅ Benefits:
✔ Risk Reduction – Payment is guaranteed if conditions are met.
✔ Secure International Trade – Protects both exporters & importers.
✔ Financing Opportunity – Sellers can get advance payments.
✔ Regulated by Banks & UCP 600 – Standardized global rules.
⚠ Risks:
❌ High Costs: Banks charge fees for processing LC transactions.
❌ Complex Documentation: Even minor errors can delay payments.
❌ Risk of Fraud: Fake documents or forged LCs can be misused.
5. Letter of Credit Usage in Global Trade
📌 Over 40% of international trade transactions use LCs for payment security.
📌 Asia-Pacific accounts for the highest LC transactions, followed by Europe & North America.
📌 Top industries using LCs: Spices & Agri Exports, Oil & Gas, Pharmaceuticals, and Machinery.
🔹 Key Fact: Indian spice exporters use Irrevocable Usance LC (30-60 days) for bulk shipments.
6. How to Apply for an LC?
🔹 Step 1: Choose a reputed bank with international trade finance expertise.
🔹 Step 2: Submit documents like Purchase Order, Invoice, and Trade Agreement.
🔹 Step 3: Decide on LC type & payment terms.
🔹 Step 4: Bank issues LC and shares it with the seller.
🔹 Step 5: Monitor shipment & document verification to avoid delays.
💡 Pro Tip: Use a SWIFT (Society for Worldwide Interbank Financial Telecommunication) LC for fast & secure processing.
7. Conclusion
A Letter of Credit is a crucial tool in global trade, ensuring smooth and secure transactions. Whether you are an importer or exporter, understanding the types, benefits, and process of LCs helps reduce financial risks and improve trade efficiency.
📢 Looking to use LC for your spice export business? Contact Aroma Xport for expert trade finance assistance!
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