Letter of credit

A letter of credit is a payment guarantee from the buyer’s bank in favor of the seller (accredited party = beneficiary), provided that the seller fulfills his obligations under the purchase contract

It is also a payment instrument in international trade that is used to secure payments between buyers and sellers. It is a binding agreement between a bank (issuing bank), the buyer (principal) and the seller (beneficiary).

A letter of credit serves to minimize the risk for both parties. The seller wants to ensure that it is paid for its goods or services, while the buyer wants to ensure that the goods or services are delivered according to the agreed terms before making payment.

The letter of credit process

1. Agreement: Buyer and seller agree on the terms of the letter of credit, including the price, delivery terms and other relevant provisions.
2. Opening of the letter of credit: The buyer instructs his bank (issuing bank) to open a letter of credit on behalf of the buyer. The bank issues the letter of credit on the basis of the agreed conditions and sends it to the seller’s bank (confirming bank) or directly to the seller.
3. Confirmation (optional): When the letter of credit is confirmed by the confirming bank, that bank assumes responsibility for payment to the seller. This usually happens when the creditworthiness of the issuing bank is questionable.
4. Delivery of the goods or services: The seller delivers the goods or provides the agreed services in accordance with the terms of the letter of credit.
5. Documentation: The seller issues the required documents in accordance with the specifications set forth in the letter of credit. These documents may include invoices, bills of lading, insurance policies, certificates, and other commercially available documents.
6. Presentation of the documents: The seller submits the documents to the seller’s bank. The bank checks the documents for compliance with the terms of the letter of credit.
7. Payment or Refusal: If the documents comply with the terms of the letter of credit, the bank is obligated to pay the amount to the seller according to the instructions in the letter of credit. If the documents do not meet the requirements, the bank may refuse payment and inform the buyer.

A letter of credit provides both the buyer and the seller with security and confidence in international trade, as payment to the seller is contingent upon compliance with the agreed terms and presentation of the correct documents.