What Is a Letter of Credit? Definition, Functions, and Types

Hello, BFI Friends! Have you ever heard of the term letter of credit when discussing export-import transactions? The term may sound unfamiliar, but it often appears in the world of international business.

Many business players use a letter of credit to ensure their transactions run smoothly. This mechanism also helps build trust between parties.

If you want to learn more about what a letter of credit is and the different types available, don’t miss this complete discussion in the article below. Let’s dive in!

What Is a Letter of Credit?

A letter of credit (L/C) is a financial instrument issued by a financial institution at the request of a buyer (importer) to guarantee payment to a seller (exporter), provided that the terms and conditions in the document are fulfilled.

In practice, letters of credit are often used in international trade transactions involving two parties from different countries. This document helps minimize risks such as payment delays, non-conforming goods, or shipping failures in cross-border trade.

Functions of a Letter of Credit

A letter of credit plays an important role in cross-border trade transactions. Its primary function is to provide payment assurance from the buyer to the seller, creating a sense of security for both parties involved.

For exporters, a letter of credit ensures that payment will still be received even though the buyer is abroad. This document serves as proof that the transaction is conducted professionally and transparently. By using an L/C, exporters can reduce the risk of default from buyers.

Meanwhile, for importers, a letter of credit also offers benefits. Importers can reassure sellers that payments will be made as agreed. The financial institution will only release funds once all documents are complete, ensuring a smooth process.

Why Is a Letter of Credit Important?

A letter of credit holds great importance in international trade. Essentially, it is a promise from the bank to guarantee that the buyer’s payment will reach the seller.

With this guarantee, businesses find it easier to gain trust from their partners, especially for high-value or high-risk transactions. In short, an L/C provides security for both parties, allowing trade cooperation to run more smoothly and professionally.

Types of Letters of Credit

Each type of letter of credit is used according to the needs and risks of international trade transactions. They each carry different characteristics in terms of security and flexibility. Here are some of the most common types:

1. Revocable Letter of Credit
   A revocable letter of credit can be canceled or changed at any time by the financial institution without the exporter’s consent. However, it is rarely used due to its high risk for exporters.

2. Irrevocable Letter of Credit
   Unlike the revocable type, an irrevocable letter of credit cannot be changed or canceled without the approval of all parties involved. This provides stronger protection for exporters as the terms and conditions remain guaranteed.

3. Confirmed Letter of Credit
   Besides being guaranteed by the importer’s bank, a confirmed letter of credit is also guaranteed by another financial institution in the exporter’s country. This provides exporters with an additional layer of security in case of issues in the importer’s country.

4. Unconfirmed Letter of Credit
   An unconfirmed letter of credit is usually guaranteed only by the issuing bank, without support from a second bank. This carries higher risk for exporters, especially if the issuing bank is less reliable.

5. Sight Letter of Credit
   A sight letter of credit is ideal for exporters who want to receive payment quickly. Payment is made immediately once the required documents are declared complete and valid by the financial institution.

6. Usance Letter of Credit
   The opposite of a sight L/C, a usance letter of credit allows the importer additional time to make payment on a deferred or credit basis.

7. Transferable Letter of Credit
   As the name suggests, a transferable L/C can be transferred to another party. This type is often used by exporters acting as intermediaries or working with suppliers.

8. Back-to-Back Letter of Credit
   Similar to a transferable L/C, but in this case, the exporter requests the financial institution to issue two separate letters of credit. It is often used by exporters without their own goods, relying on third parties, and typically involves more than one financial institution.

9. Standby Letter of Credit (SBLC)
   An SBLC functions more as a guarantee than as a direct payment tool. The financial institution pays the exporter only if the importer fails to fulfill obligations, such as non-payment or breach of contract.

What’s the Difference Between a Letter of Credit and a Line of Credit?

Although both relate to financing, a letter of credit differs from a typical credit facility. An L/C serves as a one-time payment guarantee for a specific transaction, commonly used in international trade to protect both exporters and importers.

A line of credit (LOC), on the other hand, is more flexible because it allows borrowers to access funds up to an agreed limit, repeatedly, for various needs. In short, an L/C focuses on securing international trade transactions, while an LOC serves as a revolving credit facility for short-term financing.

Advantages and Disadvantages of a Letter of Credit

In international trade, letters of credit are popular payment instruments. However, like other financial tools, they come with both pros and cons that must be understood before use.

Advantages of a Letter of Credit

• Exporters are assured of receiving payment for goods shipped.

• Importers are protected because the purchased goods are guaranteed to arrive.

• Payments are made according to the agreed terms stated in the L/C.

• Financial institutions may provide credit options for both parties.

• If exporters fail to meet their obligations, importers can delay or withhold payment.

• Importers may leverage ownership rights stated in the L/C to adjust payment arrangements.

• Both parties are shielded from foreign exchange rate risks, as L/Cs help stabilize transactions.

Disadvantages of a Letter of Credit

• Importers bear additional costs beyond the price of imported goods.

• Document processing can be time-consuming.

• Financial institutions are not responsible for damage or discrepancies in goods shipped by exporters.

• An L/C may not cover all transaction details, leading to possible miscommunication.

How to Apply for a Letter of Credit

Applying for a letter of credit usually involves a financial institution and specific documentation required from both importers and exporters. Generally, the process includes:

1. Ensuring a trade contract exists between exporter and importer.

2. Importer submits an application for a letter of credit to the issuing bank.

3. Completing the application form with transaction details, value, and required documents.

4. Issuing bank evaluates the applicant’s eligibility and risk profile.

5. If approved, the issuing bank releases the letter of credit and sends it to the correspondent bank in the exporter’s country.

6. The advising or exporter’s bank notifies the exporter of the issued L/C.

7. Exporter ships the goods and submits documents to their bank.

8. Exporter’s bank forwards the documents to the issuing bank for payment.

9. Issuing bank verifies the documents and processes payment to the exporter.

10. Importer receives the documents and collects the goods once payment is completed.

Conclusion

That was a comprehensive explanation of letters of credit and their role in facilitating international trade transactions. An L/C is not just a payment tool—it is a vital instrument that provides legal protection and security for both exporters and importers.

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