Letter of Credit (LC) is a financial instrument that is generally used in international trade transactions. LC is a letter of guarantee from the issuing bank to the exporter, which guarantees payment made by the importer for the delivery of goods or services that have been ordered. LC is one of the best ways to ensure the security of international trade transactions.
Letters of Credit have been in use since the 12th century, when traders from Northern Italy introduced them as a way to reduce risk in trading transactions. LC became increasingly popular during the 19th century, when international trade grew. Currently, LC is one of the most commonly used financial instruments in international trade.
Types of Letter of Credit
There are several types of Letter of Credit (LC), including:
A. Revocable Letter of Credit
A revocable Letter of Credit can be revoked by the issuing bank at certain times, without requiring approval from the other party. This makes importers more vulnerable to default risk.
B. Irrevocable Letter of Credit
An irrevocable Letter of Credit provides greater security for the exporter, as the issuing bank cannot revoke the LC without the consent of the other party.
C. Letter of Credit based on the form of payment
1. Sight Letter of Credit
Sight Letter of Credit is a LC that pays directly after the required documents have been submitted by the exporter.
2. Usance Letter of Credit
Usance Letter of Credit pays on a specified maturity date.
D. Letter of Credit based on the form of payment
1. Revocable Letter of Credit
Revocable Letter of Credit can be canceled or changed by the issuing bank at any time.
2. Irrevocable Letter of Credit
Irrevocable Letter of Credit provides greater security, because the issuing bank cannot revoke the LC without the approval of the other party.
3. Standby Letter of Credit
Standby Letter of Credit is a LC that is not used as a means of payment, but as a payment guarantee in the event of default from the transacting party.
How Letters of Credit Work
The process of making a LC begins when importers and exporters agree to use the LC as payment guarantee. The importing bank then gives instructions to the issuing bank to make a LC.
After the LC is made, the exporter will send goods or services to the importer. After that, the exporter will provide the necessary documents, such as invoices and proof of delivery, to the issuing bank. The issuing bank will then check the documents and if everything is in accordance with the terms of the LC, the bank will pay the exporter.
Parties involved in LC transactions include issuing banks, payment banks, importers and exporters. The issuing bank is responsible for making the LC and ensuring that all the conditions in the LC are met before making payment to the exporter. The payment bank is responsible for paying the exporter after the issuing bank verifies the documents. The importer is responsible for paying the payment bank after receiving the documents from the exporter. Exporters are responsible for providing goods or services ordered by importers, as well as providing the necessary documents.
Advantages and Disadvantages of Letter of Credit
The use of LC provides security and trust for both parties in international trade transactions. Exporters have assurance that payment will be made, while importers have assurance that the goods or services ordered will be received with the expected quality.
However, the use of LC also has drawbacks, including the costs that must be incurred to make the LC, as well as the possibility of errors in the document verification process by the issuing bank.
Examples of use cases of Letter of Credit
An exporter in Indonesia makes a transaction with an importer in the United States. Both parties agreed to use the LC as payment guarantee. After the goods are received by the importer and the necessary documents are submitted to the issuing bank, the issuing bank verifies and then pays the exporter.
Or for example the use of Letters of Credit in financial transactions, such as: An investor makes a stock transaction through a broker. Investors use LC as collateral for payments to brokers. After the shares are purchased and the necessary documents are submitted to the issuing bank, the issuing bank verifies and then pays the broker.
Letter of Credit is a financial instrument commonly used in international trade as payment guarantee. LC has several types, depending on the terms specified by both parties. The process of using a LC involves several parties, including issuing banks, payment banks, importers and exporters.
The use of LCs remains relevant in today’s international trade, however, it is necessary to pay attention to the costs incurred to make LCs and the risk of errors in the document verification process. Both parties in the transaction also need to understand well the terms specified in the LC so that problems do not occur in the future.