A Letter of Credit (LC) is a bank's promise to pay a seller on behalf of a buyer, guaranteeing payment as long as the seller meets specific conditions (like presenting correct shipping documents). Used heavily in international trade, it reduces risk by substituting the bank's creditworthiness for the buyer's, ensuring the seller gets paid and the buyer receives the goods, bridging trust gaps between unfamiliar parties.
How it Works (Simplified)
Buyer Requests LC: An importer (buyer) asks their bank (issuing bank) to open an LC for an exporter (seller).
Bank Issues LC: The buyer's bank issues the LC, guaranteeing payment to the seller.
Seller Ships Goods: The seller ships the goods, obtaining necessary documents (e.g., bill of lading, invoice).
Documents Presented: The seller presents these documents to their bank (advising/negotiating bank), which forwards them to the buyer's bank.
Payment: If documents comply with LC terms, the buyer's bank pays the seller (or their bank), and the buyer reimburses their bank.
Key Benefits
Security for Sellers: Payment is guaranteed by a bank, not just the buyer.
Trust Building: Enables trade between unfamiliar international partners.
Risk Mitigation: Reduces financial and political risks in cross-border trade.
Financing: Can allow sellers to get pre-shipment or post-shipment financing.
Key Characteristics
Documentary: Payment depends on presenting specific documents, not the goods themselves.
Irrevocable: Cannot be changed without all parties' agreement.
Costly: Involves bank fees (e.g., % of the amount) and paperwork.
Common Use Case
When a local toy dealer (buyer) imports from a new Chinese supplier (seller) with no prior relationship, an LC provides assurance that payment will be made once the toys are shipped correctly.
