Letter of Credit (or LOC) is a commonly used trade finance instrument used to ensure that the payment of goods and services will be fulfilled between a buyer and a seller. Both parties use an intermediary, namely a bank or financier, to issue a Letter of Credit and legally guarantee that the goods or services received will be paid for.
Importers and exporters normally require intermediaries such as banks or alternative financiers to guarantee payment and the delivery of goods. Cash advances or trade credits on open accounts are usually used after the buyer and seller develop a trusted relationship. Therefore, trade finance structures are used to support these relationships.
One of the parties, usually the importer, will contact a bank to serve as an intermediary and to guarantee to the seller that the goods will be paid for according to the agreement. All parties involved need to agree to the terms and sign the contract. This lowers the risk of doing business significantly, as Letters of Credit are legally binding documents that are acknowledged by 175 countries worldwide.
Letters of Credit are useful to any business that trades in large volumes, both domestically, and cross-border. They are important to ensure the cash flow of a company and lowers the risk of default due to non-payment from the end customer.
Additionally, a LC can benefit companies that structure their business around trading or services.
International traders or wholesale producers of goods are the primary users of Letters of Credit. These types of company need to be certain that they will not suffer losses from selling to overseas buyers that they are unfamiliar with.
In the unfortunate case that the recipient of the goods is unwilling or unable to pay the seller, the LC is activated, and under the terms of the agreement, the bank will be obliged to cover the missing payment. After the intermediary completes the payment, the bank will deal with the buyer according to the domestic law of the country where the buyer is located.
Risk and trust are one of the major challenges when it comes to trade, be that domestic or international. The specificity and legal weight of Letters of Credit are a big advantage, given that they are accepted and acknowledged by 175 countries, reduce the risk of doing business overseas, and provide transparent collaboration between unknown parties.
Finally, Letters of Credit provide better clarity on the transaction, as all of the goods or services supplied would be defined in detail. This provides additional comfort to the buyer as well as removing the possibility that the descriptions of the goods ordered are vastly different from what arrives.
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