A Letter of Credit is a contractual payment undertaking issued by a financial institution on behalf of a buyer of goods for the benefit of a seller, covering the amount specified in the credit, payment of which is conditional on the seller fulfilling the credit’s documentary requirements within a specific timeframe.
The primary aim of this instrument is to provide increased assurance to both the buyer and seller of the fulfilment of each party’s obligations in a commercial trade – namely the seller’s obligation to deliver the goods as agreed with the buyer, and the buyer’s obligation to pay for those goods within the specified timeframe.
Some variations to the main Letter of Credit include revolving, escalating, de-escalating, transferrable, back-to-back, as well as red and green clause letters of credit.
An issuer will use its customer’s funds to make the payment.
A Letter of Credit (or LC) 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. The rules of a Letter of Credit are issued and defined by the International Chamber of Commerce through their Uniform Customs & Practice for Documentary Credits (UCP 600), used by producers and traders worldwide. 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.
Diagram: Letter of Credit
The normal LC process flow can be diagrammatically represented as follows:
Standby Letters of Credit, Demand Guarantees and Bonds
These instruments can be classified as an independent payment undertaking, i.e. an undertaking issued by one party in support of another party’s obligations under an underlying agreement, where the issuing party’s obligations are independent of those of the supported party.
These instruments are typically required within a contractual framework with the objective of providing greater certainty and security as to a party’s fulfilment of its contractual obligations. In effect, a financial institution intervenes assuming the position of the party they are supporting, thereby replacing that party’s ability to perform with their own, providing increased comfort to the contractual party benefiting from the undertaking.
The most common requirements for the issuance of these instruments arise from the need to support bids on projects or contracts, to guarantee the performance of contractual obligations and to ensure the protection of advance payments made under an agreement. In Trade Finance terminology, the instruments issued by financial institutions to cover the aforementioned purposes are, respectively, bid, performance and advance payment bonds. When structured either as demand guarantees or stand-by letters of credit, no shipping documents are needed and only a demand is presented.