A letter of credit is a contract between a seller and buyer, moderated by the bank. It makes a payment after the agreed-upon conditions have been met. The buyer gives the bank the amount, and the bank only pays the money out to the seller once they have handed in documents as proof of performance according to the contract.
Letters of credit are complex but highly customizable agreements. Both the buyer and seller can state their requirements and arrive at a mutually agreed document. Letters of credit can also change one transaction after another between the same partners. They enable international trade by reducing credit risk between importers and exporters.
1. The primary advantage of letters of credit is that it gives protection to both the buyer and the seller.
2. The seller is reassured that after filling the administrative requirements, they will receive their payment
3. It is recognized as one of the most secure methods of payment for exporters.
4. The banks take on the risk of non-payment for the seller. It shifts the creditworthiness from the importer/buyer to the bank. This not only benefits the seller who reduces non-payment risk, but it also enables a buyer (SMEs) to initiate multiple transactions using the banks good standing.
5. The buyer gets a guarantee the seller will perform their side of the agreement in terms of the delivery date, the quality of the product, etc.
6. If the trade deal can be quickly executed, the seller can present their documents correctly.
7. Letters of credit assure payment to the seller even in disputes. They usually have a "pay now, litigate later" clause wherein the seller receives their payment if the buyer raises a dispute about the product. As long as the seller can provide documents to the bank, they receive their money. The dispute can be resolved later.
8. The payment guarantees in a letter of credit, enable the exporters to more accurately plan their finances as they are assured of payment amounts and date of payment.
9. Letters of credit can also be used by sellers to back pre-shipment financing.
1. Banks charge fees for facilitating letters of credit, so they come at a cost. The more complex or several conditions a letter of credit has, the more it will cost.
2. The seller only receives payment after strict adherence to the terms of the letter of credit.
3. Due to its strict nature, letters of credit can cause payment delays and administrative problems.
4. The buyer faces some fraud risk since the bank only makes the payment after receiving documents and not seeing the product.
Letters of credit are essential to export/import industries because they enable businesses to build new relationships internationally with lower risks, especially with unknown partners.