Letter of Credit

Financial Dictionary -> Banking -> Letter of Credit

A letter of credit or documentary credit (abbreviated LC or DC) is one of the few solutions out there for businesses that need trade finance when trading goods with foreign countries. The actual letter of credit is a document given by a bank or by another financial institution that lays out an agreement between you and your trade partner or supplier.

Letters of credit are legally binding and cannot be revoked, therefore it provides a secure method for the transaction, and ensuring payment and goods are exchanged as agreed.

Using letters of credit involves a customer of one financial institution (usually a bank), which is known as the issuing bank agreeing to authorize another bank called the advising bank, to make payment to the supplier. Payment can only go ahead if the beneficiary supplies documentary evidence as agreed in the letter, usually referring to the quality of the products and proof of their origin. Other evidence that may be required is shipping insurance documents (against damages and loss), a commercial invoice and various other similar items. This system makes letters of credit a lot more secure than telegraphic transfers. The time period of which the supplier has to be paid is also agreed upon in the letter and can be up to 90 days or more.

If you wanted to make a payment via the letters of credit method tomorrow, you would go to your bank and request a letter of credit for the payment amount, naming the supplier.

If your bank approves you can take out a loan or use retained profit to fund the transaction along with a percentage fee. (Usually no more than 10%).

The supplier and their bank are then sent a copy of the letter of credit and they present the required documents.

Your bank then transfers the money over and the goods can then be shipped. The transaction only becomes officially obligated when the documentary evidence is supplied, not when the letter of credit is sent to the supplier.