Letters of credit (LCs) or sometimes known as documentary LCs are financial instruments. It is an instrument from a bank which guarantees a buyer’s payment to a seller if certain criteria are met. There are fundamental components of each type of Letters of Credit for International Trade and as such Letters of Credit law are governed universally by a set of guidelines called the I-JCP 600 which was first produced in the 1930s by the International Chamber of Commerce (ICC).

More often than not they are issued by banks or specialist trade finance service providers offering LCs. Payment is made to the trade and commerce firm on behalf of the buyer if the terms specified in the LC are fulfilled.

Fundamentally, a letter of credit requires an importer and an exporter and their corresponding issuing bank as well as the receiving/confirming/advising bank. It is relevant where there is an exporter and an importer and there needs to be prepayment or a confirmation of payment in order for goods to be shipped. For this type of trade finance, the financiers and their creditworthiness are crucial. Letters of Credit are incredibly specific and close attention to detail is required. For example, if there is a misspelling in the contract such as the name of the goods or company name is spelt incorrectly, this could cause a non-payment and will remain so until a new, corrected Letter of credit is issued and accepted. We can delve deeper and outline the Letters of Credit advantages and disadvantages however for now we will focus on Letters of Credit Advantages.

What Is A Commercial Letter Of Credit?

A commercial letter of credit (or sometimes referred to as import/export letters of credit) is one of the oldest and most standard forms of payment for transactions in international trade. Global importers and exporters can often feel uncomfortable producing and shipping goods without any assurance of payment especially if this the first time the parties have dealt with each other. Both importers and exporters can come to an agreement that helps protect both interests whether it is to receive money or goods in exchange. Commercial letters of credit are an agreement in which the importers bank guarantees to pay the exporters bank at the time goods/services are delivered.

Letters of credit act as the primary payment mechanism for a transaction, whereby a standby letter of credit (SBLC) act as the secondary payment mechanism, i.e. a fail-safe guarantee. Some of the benefits of using Commercial Letters of Credit but not limited to are safety, risk reduction, efficiency, transparency and above all allows for safe trading.

There are different types of Letters of Credit which we won’t go into detail however here is a brief list of the types of LCs often used; Irrevocable Letter of Credit, Confirmed Letter of Credit, Transferable Letter of Credit, Letter of Credit at Sight, Deferred Letter of Credit and so on.

How Do Trade and Commerce LC’s Differ From SBLC’s

A Standby Letter of Credit is different from a Letter of Credit. Commercial letters of credit differs from Standby letters of credit (SBLC) as they are primarily used in straightforward transactions. Eg; LC’s are used in primary instrument of payment whereas SBLC’s are used as a secondary back up method of payment. The major difference between a Trade and commerce letter of credit and a Standby Letter of Credit is that a Commercial Letter of Credit (for Import or Export) is a payment method for a trade transaction whereas an SBLC supports the payment of a debt, which debt may or may not be trade related. I-Jsing an SBLC for trading such as in Import/Export transactions can be useful in so much that the SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.

Trade finance instruments such as a commercial letter of credit is the bridge in building trust in a transaction due to the nature of international dealings, distance, lack of familiarity with another party and legal differences.