Financial losses can occur when trading with foreign entities or conducting sales transactions with unfamiliar parties. For example, the goods may not be delivered, or the seller might not pay as agreed. Traders, therefore, use letters of credit to protect themselves from these issues. A standard letter of credit grants peace of mind, because it guarantees payment to the supplier when the buyer receives the goods.
Transactions involving letters of credit generally begin with an agreement between a seller and a buyer who agree to exchange goods for a certain price. These two parties may not be familiar with each other, or they may be in different localities or countries. The seller might not want to release the merchandise until he receives payment, because he has no idea if the buyer can or will actually make the payment. Conversely, the buyer might not want to release payment until she receives the merchandise, because she is unsure if the seller is capable of delivering the goods. They might be more comfortable releasing their assets if there is a guarantee that the other will fulfill their end of the bargain, and this is where the letter of credit becomes helpful.
To solve the predicament between the buyer and the seller, the buyer contracts with a bank and obtains a letter of credit naming the seller as the beneficiary. To obtain the letter of credit, the buyer can either open a line of credit with the bank or pay cash, in addition to the fees associated to this contract. The bank draws up the letter of credit, which itemizes the stipulation for payment. In international trade, issuing banks often will use a bank located in the exporter's country as an advising bank. The issuing bank forwards the letter of credit to the advising bank, which will in turn inform the seller of its specifics. The advising bank also disburses the payment when all terms of the letter of credit have been met.
The letter of credit details information about the parties involved in the sales agreement, including the issuing and advising banks. It states the conditions of the letter of credit, including terms specified by the seller, such as payment terms. The letter of credit includes information about the documents required to release payment. This information is vital, because without these documents, the bank will not release payment. The letter of credit also declares that the issuing bank is the payer, which is critical, because, as the guarantor, the bank's creditworthiness substitutes for the buyer's credit standing. If after researching the issuing bank's reputation, the buyer finds the bank reputable, he can have confidence in obtaining payment for his goods.
A standard letter of credit gives the seller a risk-free method of obtaining payment, but the process is not without some concerns. The letter of credit can create a tricky situation for the seller, because the bank only verifies receipt and correctness of the required documents, not the actual merchandise. If the merchandise is damaged or not to the buyer's satisfaction, her only recourse may be to pursue legal action, which can be a difficult process across foreign borders. If the buyer opened a line of credit to secure the letter of credit, her line of credit may be tied up throughout the entire process. There are also reasons for the seller to be wary of letters of credit. He must follow the letter of credit to the most minute detail to ensure he receives payment. Letters of credit can be cumbersome and expensive for both the buyer and the seller, because there is paperwork and fees associated with both ends of the process.