Types and usage of letters of credit necessary for trade transactions Basic knowledge that purchasing personnel should know

Understanding Letters of Credit in Trade Transactions

In the world of international trade, letters of credit play a crucial role in facilitating smooth and successful transactions between buyers and sellers.
They serve as a financial instrument that provides security and trust for both parties involved in the trade.
This article provides an overview of the different types of letters of credit and their uses, focusing on the essential information that purchasing personnel need to know.

What is a Letter of Credit?

A letter of credit is a document issued by a bank or financial institution that guarantees a seller will receive payment from a buyer.
It acts as an assurance that the buyer will pay the seller the specified amount within the agreed time frame, provided that the seller meets all the terms and conditions outlined in the letter.
In essence, it shifts the risk of non-payment from the seller to the issuing bank, offering greater security in trade transactions.

Types of Letters of Credit

There are several types of letters of credit used in international trade, each designed to cater to specific transaction needs.
Understanding these types can help purchasing personnel choose the most suitable option for their trade deals.

1. Revocable Letter of Credit

A revocable letter of credit can be altered or canceled by the issuing bank without the consent of the beneficiary.
This type offers less security to the seller since changes can be made at any time.
They are rarely used in modern trade due to their inherent uncertainties and risks.

2. Irrevocable Letter of Credit

An irrevocable letter of credit cannot be changed or canceled without the agreement of all parties involved.
This type is more common and provides more security for sellers, as it ensures that the terms will remain unchanged once the letter is issued.

3. Confirmed Letter of Credit

A confirmed letter of credit involves a second bank, known as the confirming bank, which adds its guarantee to that of the issuing bank.
This further ensures that the seller will receive payment, offering additional security in high-risk transactions or when dealing with unfamiliar banks.

4. Standby Letter of Credit

A standby letter of credit serves as a backup source of payment and is only utilized if the buyer fails to fulfill their financial obligations.
This type acts as an assurance for the seller, providing a safety net in case the transaction does not proceed as planned.

5. Transferable Letter of Credit

A transferable letter of credit allows the beneficiary to transfer part or all of the payment to one or more third parties.
This is often used in situations where intermediaries, such as agents or brokers, are involved in the transaction.

6. Back-to-Back Letter of Credit

A back-to-back letter of credit involves two separate letters of credit.
The first letter is issued in favor of the seller, while the second is issued in favor of the seller’s supplier.
This is often utilized in complex transactions where multiple parties and shipments are involved.

The Process of Using a Letter of Credit

The process of using a letter of credit in a trade transaction involves several steps that purchasing personnel should be familiar with to ensure smooth execution.

1. Agreement and Application

The buyer and seller agree on the terms and conditions of the transaction, including the use of a letter of credit as the payment method.
The buyer then applies for a letter of credit from their bank, providing all necessary details and documentation.

2. Issuance

The issuing bank reviews the application and, if approved, issues the letter of credit in favor of the seller.
The letter is sent to the seller’s bank, also known as the advising bank, which notifies the seller of its issuance.

3. Shipment and Documentation

The seller ships the goods to the buyer and prepares the required documents specified in the letter of credit.
These may include commercial invoices, shipping documents, and certificates of origin.

4. Presentation and Payment

The seller presents the documents to the advising bank, which examines them for compliance with the letter’s terms.
If the documents are in order, the advising bank forwards them to the issuing bank, which then releases the payment to the seller.

5. Settlement

The buyer receives the goods and the necessary documents, ensuring that the terms of the letter of credit are fulfilled.
The issuing bank then settles the payment by debiting the buyer’s account.

Advantages of Using Letters of Credit

There are several benefits of using letters of credit in trade transactions:

1. Risk Mitigation

Letters of credit significantly reduce the risk of non-payment for sellers, as the issuing bank takes on the responsibility of payment.

2. Trust and Security

The involvement of reputable banks adds a layer of trust and security to the transaction for both parties.

3. Global Acceptance

Letters of credit are widely accepted and understood in international trade, making them a preferred choice for cross-border transactions.

4. Facilitating New Business Relationships

Using a letter of credit can help build relationships with new or unfamiliar trade partners by providing assurance of payment.

Conclusion

Understanding the types and usage of letters of credit is essential for purchasing personnel engaged in international trade transactions.
These financial instruments offer security, trust, and flexibility in managing payments across borders.
By choosing the right type of letter of credit for each transaction and understanding the process involved, purchasing personnel can facilitate successful trade operations while mitigating risks.