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Letter of credit


In modern business practice, a letter of credit is a written undertaking from a bank to pay a beneficiary against the delivery of a specified set of documents.

A letter of credit is a method of payment, considered less secure than payment in advance but more secure than documentary collections and open account from the seller's point of view. From the buyer's point of view it offers more security than payment in advance but less security than documentary collections or open account terms.

However, it is generally considered that Letters of Credit (otherwise known as "Documentary Credits") offer a good balance of security between the buyer and the seller, because both the buyer and seller rely upon the security of banks and the banking system to ensure that payment is received and goods are provided. In a Letter of Credit transaction the goods are consigned to the order of the issuing bank, meaning that the bank will not release control of the goods until the buyer has either paid or undertaken to pay the bank for the documents.

In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. The bank will examine the beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. The current version, UCP600, became effective July 1, 2007.

The name "letter of credit" derives from the French word "accréditation", a power to do something, which derives from the Latin "accreditivus", meaning trust.

UCP 600 defines a number of terms related to letters of credit. These include:

After a sales contract has been negotiated and letter of credit has been agreed upon as the method of payment, the Applicant will contact a bank to ask for a letter of credit to be issued, and once the issuing bank has ascertained that the Applicant will be able to pay for the goods it will issue the letter of credit. Once the Beneficiary receives the letter of credit it will check the terms to ensure that it matches with the contract, and will either arrange for shipment of the goods or ask for an amendment to the letter of credit so that it meets with the terms of the contract. The letter of credit is limited by time, in terms of the validity of the credit, the latest date of shipment, and in terms of how long after shipment the documents may be presented to the Nominated Bank.


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