What is Letter of Credit?

What is Letter of Credit?

20 Dec 2018 01:00 PM

Meaning: Letter Of Credit (LC)

A LC or what is known as letter of credit is an efficient mechanism to make payment, mostly in cases of international trade. It is a document acting as a guarantee that the payment will be made by the buyer to the seller i.e. the exporter of goods and assets. It provides a surety of payment to the exporter as the document has the goodwill of bank associated with it and is routed through the bank. Since there are high chances of parties being strangers to one another and having little information about each other, Letter of credit is considered to be safe mode of payment. Being unknown to each other, might raise an anticipation in the mind of the seller of payment failure from the importer’s end after the receipt of goods or assets.

A letter of credit is a safe document and is enforceable in the court of law wherein the bank guarantees to make payment on behalf of the importer or the buyer in case the buyer fails to make payment to the seller in the given time duration. This, thus, helps to remove the risk ofnon-payment faced by the exporter of goods. Today, the letter of credit is used on a day to day basis in the international trade markets.

A Letter of Credit is also known as banker’s commercial credit or documentary credit. It is a fundamental and primary method of handling the risk or exposure faced by traders in the international or global markets. The exporter or the seller has a right of ensured payment on the presentation of certain necessary documents to the bank that are mentioned in the letter of credit and are necessary for trade. It is humanly easier for a person or trader to trust the bank in place of the buyer of goods, since bank is a huge financial institution with its creditworthiness attached. This makes international trade a faithful and free market for the traders.

Letter of credit is a service provided by the banks to the buyer of commodities and banks charge a fee for providing it. Since the banks have to make payment on buyer’s failure, they require some security and thus they ask the buyer to provide some collateral asset to the bank, to recover their money in case the buyer fails to make payment to the bank on time. The size of collateral naturally depends upon the amount of the letter of credit or the amount of the transaction. The international chamber of commerce frames, enacts and governs all the rules and regulations related to the letter of credit, the services related to it and the fee charged by banks for this service.

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