What is a Letter of Credit ?

1. The exporting and importing parties agree on payment by a letter of credit system.

2. Next, the importer goes to his own bank, that is, the issuing bank, and instructs the issuing bank to open a letter of credit in favor of the exporter.

3. The issuing bank notifies the exporter's bank, namely the correspondent bank, that a letter of credit has been opened.

4. At this stage, the exporter's bank informs the exporter that a letter of credit has been opened in favor of the exporter.

5. The exporter ships the goods to the importer (letter of credit shipping).

6. In this step, the exporter delivers the shipping document to the correspondent bank and receives the money for the goods sent in return.

7. The correspondent bank gives the shipping document to the importer's bank and the issuing bank (importer's bank) makes the payment to the correspondent bank.

8. The issuing bank gives the shipping document to the importer and the importer makes the payment to the issuing bank.

9. Finally, the importer receives the goods from the customs with the shipping document.

What Is the Purpose of Letter of Credit?

The primary purpose of an international letter of credit is to provide financial security and payment assurance in global trade. It protects the seller by guaranteeing that payment will be made as long as the contractual obligations are fulfilled. At the same time, it safeguards the buyer by ensuring that funds are only released when the agreed-upon goods or services are delivered as specified.

Beyond payment security, it also helps facilitate transactions between unfamiliar parties, reducing the risks associated with cross-border trade. It minimizes concerns over non-payment, economic instability, or political uncertainties by involving banks as trusted intermediaries. Additionally, it streamlines the payment process, enhances trust between trading partners, and provides a structured framework for financial transactions, making it an essential tool in global commerce.

What are the Types of Letters of Credit?

There are various types of letter of credit, each serving different trade needs and offering varying levels of security.

1. Revocable Letter of Credit: 

In this type of letter of credit, the importer has the authority to go and remove the letter of credit at his own will without asking the exporter. It is not a preferred method because it is not a reliable method.

2. Irrevocable Letter of Credit:

This type of letter of credit cannot be canceled or changed without the mutual consent of the parties. To withdraw or cancel, the consent of all parties is required.

3. Confirmed Letter of Credit:

Contrary to the unconfirmed letter of credit, it is confirmed by the correspondent bank and an additional guarantee is given that the price of the goods will be paid. If the buyer notifies the seller by attaching a bank confirmation, it means that the bank that issued the letter of credit assumes all responsibility.

4. Unconfirmed Letter of Credit:

In this type of letter of credit, the correspondent bank does not assume any financial responsibility. It is sufficient only to inform the beneficiary that the letter of credit has been opened and inform about the conditions of the letter of credit.

5. Revolving Letter of Credit:

These are letters of credit that are not invalidated once used. If there is a continuous purchase and sale agreement between the importer and the exporter, a single letter of credit is opened to cover the shipment to be made within the agreed period, instead of opening a separate letter of credit for each shipment.

6. Red Clause Letter of Credit:

It is a type of letter of credit stating that a prepayment will be made to be used in the processing, packaging, transportation, or storage processes of the goods specified in red and included in the document of the letter of credit.

7. Green Clause Letter of Credit:

It is a type of letter of credit that allows the importer to be paid in advance. It is made against invoices and receipts showing the various payments made or the state of the goods as they are stored.

8. Back to Back Letter of Credit:

It consists of two different letter of credit transactions that are independent of each other. It is a payment method that takes place in the form of a letter of credit in which the beneficiary of the first letter of credit is the supervisor of the second letter of credit.

9. Transferable Letter of Credit:

It is the type of transaction that enables the liability of beneficiary to be transferred to another beneficiary. This transfer can only be made once.

10. Stand-by Letter of Credit:

It is a type of letter of credit that acts like a letter of guarantee. It includes a service, not a good. It is used to guarantee the service.

Among these, the most common types of letters of credit used in international trade are the irrevocable, confirmed, and transferable letters of credit, as they provide higher security and flexibility for both importers and exporters. Understanding the different types of letter of credit helps businesses choose the most suitable one based on their trade agreements, risk tolerance, and financial needs.

Difference Between Revocable and Irrevocable Letter of Credit

A Revocable Letter of Credit is a type of LC that the issuing bank can modify or cancel at any time without prior notice to the seller, making it highly risky and rarely used in international trade. Since the issuing bank retains full control over changes, sellers have no guarantee of receiving payment. The security for the seller is minimal, as the bank can withdraw its commitment at any moment, leading to potential financial losses. Revocable LCs are uncommon in global trade due to their lack of reliability and are typically used only in transactions where the buyer and seller have a strong, trusting relationship. The issuing bank has full discretion to amend or cancel the credit, while the confirming bank (if involved) has no obligation to honor payment, as its role is secondary and not binding.

On the other hand, an Irrevocable Letter of Credit provides a binding commitment from the issuing bank, meaning it cannot be modified or canceled without the agreement of all involved parties, including the seller. This guarantees payment to the seller as long as the stipulated terms and conditions are met, significantly reducing the risk of non-payment. Because of this strong security, irrevocable LCs are the preferred choice in international trade, ensuring smooth transactions, especially when dealing with unfamiliar buyers or across different legal systems. The issuing bank plays a crucial role in guaranteeing payment, while the confirming bank (if present) adds an extra layer of security by independently verifying and committing to payment, making the transaction even more reliable for the seller. Due to these advantages, most modern LCs are issued as irrevocable by default, ensuring fairness and stability in global trade.

Difference Between Confirmed and Unconfirmed LC

A confirmed letter of credit (LC) and an unconfirmed LC differ primarily in terms of cost, institutional involvement, amendment rights, process, and credibility checks. The most notable distinction is the cost. Unconfirmed LCs are generally less expensive since they do not require additional confirmation charges, whereas confirmed LCs incur extra costs due to the involvement of a second bank.

In an unconfirmed LC, the issuing bank is solely responsible for providing an irrevocable payment guarantee to the exporter. However, in a confirmed LC, a second bank, known as the confirming bank, adds its own guarantee, offering an additional layer of security to the seller. This confirmation ensures that both banks hold separate payment obligations.

When it comes to amendments, the seller, or beneficiary, is the only party that can request changes in an unconfirmed LC through the applicant, who is the importer. In contrast, a confirmed LC allows the confirming bank to directly propose amendments to the issuing bank. The payment process also differs. Under an unconfirmed LC, the issuing bank is responsible for making the payment, while the second bank merely acts as an intermediary. Conversely, in a confirmed LC, the seller first seeks payment from the confirming bank, which then requests reimbursement from the issuing bank.

Lastly, the verification of the importer’s credibility varies between the two. In an unconfirmed LC, this responsibility falls solely on the issuing bank, while in a confirmed LC, the confirming bank undertakes this task, adding an extra layer of due diligence. These differences highlight how a confirmed LC provides stronger payment security but comes at a higher cost, while an unconfirmed LC remains a more cost-effective yet less secure option for exporters.

What Is an Example of a Letter of Credit?

Here is a basic letter of credit example, which outlines the standard structure and key details typically included in such a document.

What are Advantages and Disadvantages of a Letter of Credit ?

A Letter of Credit is a powerful tool that enhances security in trade transactions, but businesses must weigh its advantages against the costs and complexities involved. Proper understanding and compliance with LC terms can help businesses maximize its benefits while minimizing risks.

A Letter of Credit (LC) offers significant advantages for both importers and exporters, and the advantages of a letter of credit make international trade more secure and efficient. It enables businesses to enter new markets by facilitating transactions with unfamiliar overseas partners, reducing concerns about payment risks. LCs are highly customizable, allowing both parties to agree on specific terms and conditions that suit their needs. For exporters, timely payment is guaranteed since the issuing bank assumes responsibility, eliminating credit risk and providing proof of the buyer’s financial stability. This security also enhances cash flow, enabling sellers to finance production and ensure timely shipments, sometimes even benefiting from pre-shipment financing. However, despite these benefits, LCs also have some drawbacks. The process can be time-consuming due to extensive documentation requirements, and the associated bank fees can add to the overall cost. When evaluating letter of credit pros and cons, businesses should consider fraud risks, as banks assess shipping documents rather than the actual goods, and currency fluctuations can further complicate transactions. Additionally, the strict time frame for delivery can be challenging for exporters, and in rare cases, if the issuing bank defaults, payment failure may occur.

Enhancing Trade Security with Letters of Credit and TradeAtlas

In today's globalized world, ensuring both security and efficiency in international trade has never been more important. Letters of Credit (LCs) serve as a key financial instrument, helping importers and exporters minimize risks and facilitate seamless cross-border transactions. However, while LCs provide financial security, businesses still face challenges in finding reliable trading partners and verifying trade data. This is where TradeAtlas becomes an essential tool, as it offers a comprehensive database of global trade data that helps businesses identify actual suppliers and buyers, reducing uncertainties in international transactions. By integrating TradeAtlas’s database with secure payment methods like LCs, companies can navigate global markets with confidence, minimizing risks and maximizing trade opportunities.

For detailed information on the subject of payment methods in foreign trade, you can review the content “What are the Payment Methods in Foreign Trade?”.