What is a Letter of Credit?
Logistics & ShippingThe ocean freight world is not short of its complex paperwork and documents. You may know the more important ones such as Bill of Lading and packing list. But there are others that are equally important. In this post, we’ll take a more detailed look at the Letter of Credit, what it is, and how it works.
What is a Letter of Credit?
A Letter of Credit, according to the ICC, is:
“A promise by a bank on behalf of the buyer (customer/importer) to pay the seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline.”
In other words, the Letter of Credit is a way, and one of the most common ones, in which an importer promises to pay his foreign seller. It acts as a formal, binding legal agreement. Plus, shippers generally consider it one of the most secure methods of payment.
In every transaction, there’s a seller and a buyer. In the large world of trade, there’s no way to know that the person with whom you’re dealing is reliable. And given the lengthy times needed for cargo to arrive via maritime shipping, importers need to guarantee payment prior to goods arrival. This assurance comes in the form of the Letter of Credit.
How does a Letter of Credit work?
It works as a standing instruction the importer’s bank makes to an bank that guarantees payment to the exporter in advance. This however, first requires both parties to fulfill certain requirements. The buyer usually draws up these terms and conditions which usually include:
- Origin and destination port
- Modes of transport
- Shipping line
- Description of goods including technical description, if applicable
- Quantity of goods
- Required documents
- Consignee details
- Notifying party details
- Latest shipment date
Once the seller agrees to these terms, the buyer’s bank (or issuing bank) goes ahead to issue the Letter of Credit. This is sent to both the seller and his bank (nominated bank). Based on these conditions, the seller readies his goods and documents. Once the shipment is made, the seller brings copies of the documents to the nominated bank to verify them.
When the nominated bank has corroborated that the documents matches those listed on the Letter of Credit, it pays the seller. It then goes to the issuing bank with the documents. The issuing bank then does its own corroboration. When it’s satisfied, it reimburses the nominated bank the money it has paid to the seller.
When that’s done, it notifies the buyer that the shipment has been made and all the documents are correct and in its possession. The buyer then pays the issuing bank, who signs the Bill of Lading to allows shipment release to the buyer.
Here’s an infographic to illustrate the entire process regarding the Letter of Credit:
Why you should use a Letter of Credit
The Letter of Credit equals out the risk for both the seller and buyer. It protects the seller by guaranteeing payment as long as the seller meets all terms and conditions agreed on. From the buyer’s end, a Letter of Credit also protects him. If the seller does not deliver his goods, the buyer may be able to get a ‘standby Letter of Credit’. This works like a fine/penalty to the seller for failing to deliver and a refund for the buyer.
Things to note
- Banks usually charge an interest for this service. This of course varies from bank to bank so it’s best to check with your bank directly for their rates.
- There’s no guarantee that what’s listed on the Letter of Credit is actually what’s loaded. Hiring independent surveyors or travelling to monitor cargo loading first hand is the best solution to this.
- In the event of discrepancies, the buyer may either waive it or renegotiate certain terms and conditions. This helps to make up for any losses.
- A Letter of Credit reduces risk but a little mistake can be costly. Make sure to get all the details correct by checking and double-checking.
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