Letters of credit

In modern business practice, a letter of credit (LC) also known as a Documentary Credit, is a written commitment by a bank issued after a request by an importer (foreign buyer) that payment will be made to the beneficiary (exporter) provided that the terms and conditions stated in the LC been met, as evidenced by the presentation of specified documents.

A letter of credit is a method of payment that is an important part of international trade. They are particularly useful where the buyer and seller may not know each other personally and are separated by distance, differing laws in each country and different trading customs. It is generally considered that Letters of Credit 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. Banks will typically require collateral from the purchaser for issuing a letter of credit and will charge a fee which is often a percentage of the amount covered by the letter of credit.

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 in terms of time, the validity of credit, the last date of shipment, and in terms of how much late after shipment the documents may be presented to the Nominated Bank.

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