Letters of Credit
A letter of credit is a financial tool that can be very useful in some situations.
A letter of credit is a document issued by a third party that guarantees payment for goods or services when the seller provides acceptable documentation. Letters of credit are usually issued by banks or other financial institutions.
Most letters of credit are import/export letters of credit, which, as the name implies, are letters of credit that are used in international trade.
Letters of credit are most often used in international trade, where they are governed by the Uniform Customs and Practice for Documentary Credits (or UCP), the rules of the International Chamber of Commerce.
All letters of credit governed by the current UCP are irrevocable letters of credit.
A confirmed letter of credit is one where a second bank agrees to pay the letter of credit at the request of the issuing bank.
An unconfirmed letter of credit is guaranteed only by the issuing bank. This is the most common form with regard to confirmation.
A letter of credit may also be a transferrable letter of credit. It allows the named beneficiary to present its own documentation but transfer all or part of the payment to the actual suppliers.
A letter of credit may also be at sight, which is payable as soon as the documentation has been presented and verified, or payment may be deferred. Deferred letters of credit are also called a usance letter of credit and may be put off until a certain time period has passed or the buyer has had the opportunity to inspect or even sell the related goods.
Letter of credit transactions are not without risks. The risks inherent in these types of transactions include:
- Fraud risk, in which the payment is obtained through the use of falsified or forged documents for worthless or non-existent merchandise
- Regulatory risk, in which government action may prevent completion of the transaction
- Legal risk, in which legal action prevents completion of the transaction
- Force majeure risk, in which completion of the transaction is prevented by an external force, such as war or a natural disaster
In addition, the normal risks inherent in transactions, such as non-delivery, shipping less than was ordered, inferior quality merchandise, early or late shipment, or goods being damaged in transit, apply.