A letter of credit (LC) is a financial contract between a bank, a banks customer, and a beneficiary. It is a document sent from a bank or financial institution that guarantees that a seller will receive a buyer's payment on time and for the full amount. LCs are used in international trade deals and can be thought of as a certified cheque in retail banking. There are different types of LCs that may be used, depending on the circumstances. Some key terms related to LCs include:
- Issuing bank: The financial institution that reviews and approves the applicant for the letter of credit and holds onto the funds involved in the transaction.
- Negotiating bank: The financial institution that works on the beneficiary’s side of the transaction, and pays the beneficiary in case of default. They liaise with the issuing bank.
- Advising bank: The financial institution that receives the letter of credit, and informs the beneficiary when the applicant’s bank approves the letter of credit.
- Confirming bank: The financial institution that guarantees the payment to the beneficiary.
- Intermediary: A third party that can help applicants and beneficiaries sort out details of a letter of credit.
LCs can be used for multiple payments within a specific time frame, as in the case of revolving letters of credit. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year. Commercial letters of credit, on the other hand, are involved in commercial transactions, often in international trade deals. The bank makes a direct payment to the beneficiary in this case.
