What is a letter of credit?
Consider a buyer and seller in the South-East Asian market. The buyer is from Thailand, and the seller is from Singapore. The question arises as to whether the seller is willing to part with the goods first or the buyer is willing to transfer the funds first. The reason such a situation arises is due to a lack of trust and distance. The seller does not have the means to check the creditworthiness of the buyer in Thailand. In such a high-risk situation between buyer and seller, a letter of credit is issued.
The bank plays the role of a trustable third party and acts as an intermediary to assist the transaction between buyer and seller. Here the bank is introduced as an independent entity authorized to keep in possession the funds until certain criteria necessary for the funds to be released are fulfilled. Keeping in mind the sensitivities of such a transaction, escrow providers such as Tazapay have built a secure platform for international B2B payments.
A letter of credit is a trade finance tool that guarantees a buyer’s payment to a seller with a high level of confidence. A letter of credit comes into play when there is a need for prepayment for the goods to be shipped.
Letters of credit are fundamental to international trade because-
Trust is extremely important in a buyer-seller relationship
The seller must get paid on time and in full
Countries have different trade laws. A uniform system is beneficial to both importers and exporters
A letter of credit greatly reduces risk in trade by guaranteeing the buyer’s payment to the seller when certain criteria are met. It also guarantees the buyer dispatch of goods before the payment has been made
The LOC is universally governed by UCP 600 issued by the international chamber of commerce.
How does it work?
Once the sales agreement is finalized, the buyer (opener or applicant) applies to their bank (opener or issuing bank) for a letter of credit. The issuing bank may freeze some funds of the buyer at the bank or ask for payment upfront.
The issuing bank drafts and sends the LOC to the seller’s bank (advising bank). The seller’s bank reviews the LOC and sends it to the seller. The seller dispatches the goods and yields the necessary documents to their bank.
The seller’s bank checks and approves the documents ensuring that they comply with LOC terms. Then submit it back to the buyer’s bank.
The buyer's bank transfers the amount to the seller's bank. The buyer's account is debited, and their bank releases the documents to the buyer to claim the goods.
Commercial LC
Credit on Sight
Time Credit
Standby Letter of Credit (SBLC)
Revocable Credit
Irrevocable Credit
Transferable Credit
Thus, a letter of credit is designed to protect both buyer and seller. It can help businesses venture into new foreign markets and grow. However, escrow is preferred more for enhanced safety at much convenient price.
