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A letter of credit is one of the pillars modern business and trade. Much of international trade depends on firms being able to guarantee the surety of payments to other firms in faraway nations; import and export would almost come to a standstill.
A letter of credit (sometimes also called a credit letter), is, in short, a document ensuring that a seller will receive the full payment from the buyer. In case the buyer is unable to make the payment, the bank steps in to fulfil the obligation. The bank also collects a fee for its part.
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Normally, these are the stages of getting a letter of credit transaction issued:
These are some main types of letter of credit
A confirmed letter of a credit is, in a way, an insurance on top of the already existing letter of credit from a bank. This may be issued by a separate bank guaranteeing the payment of money if the first bank fails to do so. In an unconfirmed letter of credit, there is only one bank that is liable to guarantee the transaction.
A revolving letter of credit permits a customer to complete more than one transaction within a time period, instead of having to get letters of credit issued for each transaction. This letter of credit is of great convenience to the bank’s customer.
Sometimes abbreviated as SBLC, this ensures that the seller receives payment from the bank, in the event of the buyer (that is, the bank’s client) being in a situation where they are unable to stick to the agreed upon terms. It is especially important in trade since it protects the contractual terms.
An irrevocable letter of credit is an ironclad guarantee of payment to the seller. It means that the seller will receive the due amount from the buyer’s end, come what may. Making a change to the irrevocable letter of credit is difficult; it would need agreement from all three parties. This is what distinguishes it from its counterpart, the revocable letter of credit. The revocable letter of credit is one whose terms and conditions can be modified by the issuing bank.
The Red Clause letter of credit is an advance of sorts, in the crudest terms, because the nominated bank makes an advance payment to the seller. The name comes from the fact that the document contains a provision or clause (often highlighted in red) that authorizes this action.
Since there is a possibility of great confusion regarding the rules governing letters of credit, some rules were developed by the International Chamber of Commerce. Most of the letters of credit used in commercial transactions are governed by these rules, which are called Uniform Customs and Practice for Documentary Credits. The current version of rules, called UCP 600, was issued in 2007.
The need for a letter of credit originates in the uncertainty of trade. Even in today’s connected world, it is quite difficult to ensure that a buyer is genuine and can hold up their end of the bargain. Sellers may be wary of sending goods to a location over which they have no control or influence. Having a letter of credit solves these problems adequately.
There are many reasons for using letters of credit, chief among them being safety and ease. They reduce the risk for sellers as payment is ensured and is also relatively easy to secure. Besides ensuring payment, the letter of credit also helps to manage cash flows and ensure a buyer’s solvency.
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