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What Is a Letter of Credit? How Does It Work?

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A Letter of Credit is an important financial tool in the buying-selling process. A Letter of Credit is issued by shipping finance banks to the seller as a guarantee of payment from the buyer. A Letter of Credit guarantees to pay the seller the complete amount of the purchase. The Letter of Credit is crucial in international trade for many reasons such as the location of each party, difficulty in knowing both parties personally and different laws in different countries. A detailed understanding of the Letter of Credit (‘LC’) and its terms and conditions is invaluable in international commerce.

How does the LC work?

There are many ways for businesses to get paid by the vendors and customers. A Letter of Credit is one such financial tool. Businesses prefer wire transfers, cheques or cash. An LC enables the vendor to engage in business without having to offer a verbal agreement or a personal guarantee.

A Letter of Credit can be for 90, 60, or 30 days. This means that the promised money is due in 90, 60, or 30 days respectively.

Letter of Credit fee

Letters of credit are issued by banks for international trade. In return, they collect a fee. This fee is termed as a Letter of Credit fee. The value of the fee is generally a percentage of the size of the LC. The most important thing to ensure is that the bank is situated in the same country as that of a buyer. Each business selling its products must deal with the foreign bank issuing LCs.

An LC works like an escrow account. It works like a third party, completing  the transaction agreed between two parties. The key difference is that the bank which is providing the funds is located in another country. This has its advantages: when the bank is located in the country where the transaction is taking place, they will be familiar with the rules and regulations at local level. They will know the economic and business climate of the country. This will ensure that the transaction occurs without hitches.

The different parties of the LC transaction

       The beneficiary: The seller  is the beneficiary.

       The applicant: The buyer  is the applicant.

       The intermediary: Intermediaries  connect the beneficiaries and applicants by letting them make a deal. They help in the creation of the LC. The intermediary can be another party or an employee of the negotiating or issuing bank.

       The negotiating bank: The negotiating bank works on the side of the beneficiary in the transaction and handles all the transactions to get the seller paid.

       The shipper: The role of the shipper is to deliver the goods for any transaction.

       The freight forwarder: In case the transaction involves large-sized items or large amounts of money then the freight forwarder has to make sure the shipping gets completed smoothly. They may ensure the fees related to import, export, and others are paid. 

       Legal counsel:  They ensure all the legal requirements are met, based on the  countries that are part of the trade. The role of lawyers is also to resolve any disputes during the transaction.

Things to consider when using letters of credit

It is important to go through the terms and conditions first. This step is crucial. Take care to check if the LC is 60 days, 90 days or another time frame. Failure to understand in detail may result in being liable for the whole transaction. 

Summary

Small and large businesses dealing with buyers as a part of international transactions can benefit greatly from a Letter of Credit. The Letter of Credit may become invalid if the terms are not properly followed, the opposite can be a great opportunity for investing on the stock market.

 

This would mean the seller would not be paid. If LCs are used properly the transaction will go smoothly and sellers will be paid on time,  regardless of the country from where they are doing business.

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