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Last edited 05 Nov 2019
Letter of credit
A letter of credit is a financial document used to reduce risk in the import and export of goods: to give assurance both to importers that they will receive their goods and to exporters that they will receive payment. It is sometimes referred to as 'documentary credit'.
For example, a contractor who has ordered curtain walling from Europe needs certainty that it will arrive by the due date, while the manufacturer wants assurance that they will be paid for the curtain walling that has been manufactured and shipped. If this were not the case, imported goods previously ordered might never arrive and exported goods might not be paid for. Given there are usually large distances involved in such transactions, as well as different legal systems and language barriers, any such disputes could be difficult to resolve.
 Benefits for sellers (exporters) of goods and services
A letter of credit is a guarantee from a bank specifying that the seller (exporter) will receive a specified sum of money within a specified period as payment from a particular buyer. In return, the bank demands that specific terms are met, such as receiving certain documents as proof eg, shipping confirmation, etc. To receive payment, exporters must keep strictly to the terms of the letter, which normally requires providing documentary evidence that the goods supplied are exactly what they contracted to supply.
As long as the exporter meets all the terms and conditions, the letter of credit provides them with one of the most secure methods of payment. If, following issue of the letter of credit, the buyer does not pay the seller, the risk is then transferred from the seller to the bank.
A letter of credit gives the buyer (importer) assurance that the seller will honour their side of the bargain and provide documentary proof for it. A buyer usually arranges a letter of credit with their own bank – referred to as the ‘issuing bank’. Although they can be useful, importers should typically only use letters of credit at the insistence of exporters and/or if they are required by national controls.
Letters of credit can result in higher costs – banks will charge for them and so they may not be justifiable in relation to the order’s value. Costly delays, bureaucracy and other administrative problems are also possible.
 Government advice
- Whether the country being exported to requires one.
- Does the value of the order justify the associated bank charges and extra costs?
- Is the customer creditworthy and do they have a track record with the exporter?
- Is the country being exported to politically stable and a good international trading partner?
- Is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
- Seek other advice and guidance – a bank may be able to advise on trading with the country.
 Types of letter of credit
There are numerous types of letter of credit, and some are more secure than others, but the main ones are:
- Irrevocable – cannot be changed or cancelled unless all parties agree.
- Revocable – can be changed or cancelled by the bank at any time and for any reason. These provide less security than the irrevocable type.
- Confirmed – at the request of the seller, the seller’s bank usually checks whether the buyer’s letter of credit is valid; the seller may, for extra security, require the bank to ‘confirm’ the letter. By this act of confirmation, the sellers bank agrees to guarantee payment if the buyer’s (issuing) bank fails to honour it.
- Unconfirmed – an unconfirmed letter of credit is not as secure as the confirmed type.
- Transferable – can be passed on to another beneficiary (party receiving payment) eg, when intermediaries are involved.
- Revolving – these can be used to cover several transactions between the same buyer and seller.
 Related articles on Designing Buildings Wiki
- 5 Essential Tips for the Import / Export Trade
- Advance payment bond.
- Bonds and guarantees.
- Cash flow.
- Late payment.
- Parent company guarantee.
- Performance bonds.
- Retention of title.
- Vesting certificate.
 External references
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