A letter of credit or a LC is known to be a mechanism of payment commonly used in international trade. It acts as a guarantee of payment for the seller or the exporter of goods since it is routed through bank and has its credit worthiness attached. Letter of credit is considered safe in case of international trade since there are high chances of the parties being unknown to each other. This might give rise to an anticipation on the side of the seller of non-payment for the goods or assets from the buyer of the commodities.
The letter of credit is a legally enforceable written guarantee from a credit worthy bank to make payment on behalf of the buyer of goods. This mitigates the risk faced by the seller in trade. The bank gives an underwriting to pay in case there is a default on behalf of the buyer of goods. A letter of credit is used on a regular basis in the international markets.
Documentary credit and banker’s commercial credit are some other names of the Letter of Credit. It is a basic and primary way of dealing with the risk faced in international transactions by the seller of goods and ensures payment on presentation of the required documents of the seller of goods to the bank that promises to pay money in the letter of credit. It becomes easier for the seller to trust the bank than to rely upon the importer or the buyer of goods.
Banks charge a fee from the importer or the buyer of goods to provide them with the service of letter of credit and also demand some collateral to ensure that the bank does not have to face the loss. The bank has the right to recover its money from the collateral involved incase the importer defaults to make payment to the bank. In the scenario today. Letter of credit, the services associated, the fee that can be charged and the rules and regulations are all framed and enacted and governed by the international chamber of commerce.
A letter of credit has various advantages and disadvantages. A letter of credit is highly preferred as it is a customizable document i.e. it can be modified according to the terms of the parties involved in the contract of trade. It ensures safety of payment being made hence enhances the trust of traders in dealing internationally. A seller can easily avail pe shipment finance in order to prepare and ship the goods of ale against the letter of credit. A letter of credit also ensures timely payment and helps the seller or the exporter to plan the cash flows.
A letter of credit although highly used has certain backlogs associated. It leads to an extra cost on the buyer or the importer i.e. the buyer has to pay the fee charged by bank for the letter of credit service. The formalities involved in obtaining a letter of credit are pretty time consuming. Also, there is a possibility of misuse of the letter of credit which raises the issue of fraud. A letter of credit is time bound, hence the seller has to make payment within the time duration of the letter.
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