What Is a Letter of Credit in Shipping, and How Does It Work?

Buyers may fail to pay the exporters for the delivered goods, and importers could pay in advance without receiving the shipment. Not to mention that the distances the cargo travels complicate the settling of any disputes.

The simplest way of minimising the aforementioned risks is using a Letter of Credit. UK banks sometimes refer to it as “Documentary Credit.” It guarantees that the seller will receive the payment and the buyer will receive the goods.

Depending on several factors, there are different kinds of Letters of Credit a business can use. Here we’ll discuss who issues a Letter of Credit, how it works, and the requirements for applicants.

Who Issues Letter of Credit

Businesses new to international trade may wonder who issues Letter of Credit documents.

Banks are the only entities authorised to issue Letters of Credit to eligible applicants. Consequently, they guarantee sellers will receive a sufficient payment within a set timeframe. In turn, banks obligate sellers to adhere to strict terms and conditions. For example, they may ask to view shipping confirmation and similar documentation.

The Procedure for Letter of Credit: Requirements

Banks may have different rules for issuing a Letter of Credit. UK-based businesses considering applying for this document should outline the following:

• A description of the cargo, including its quantity
• The required documents (Bill of Lading, Certificate of Origin, Commercial Invoice, etc.)
• Contact information for when the goods arrive
• Payment terms

Depending on the nature of the business, it may include additional information. Before contacting your bank about the procedure for Letter of Credit, discuss your expectations with the other parties.

How Does Letter of Credit Work?

Once the seller and the buyer decide to proceed with the shipment, the buyer’s bank sends the Letter of Credit to the seller’s bank. UK-based banks can confirm Letters of Credit if the documentation is in order. This allows them to guarantee payment even if the buyer’s bank fails to release the funds.

Using a Letter of Credit in International Trade

Some businesses assume it’s necessary to use a Letter of Credit in international trade. But that’s not always the case.

Before asking an overseas customer to apply at a bank, exporters should consider whether their country requires a Letter of Credit. In shipping, these documents may cause unnecessary complications.

Exporters should also consider the following factors:

• The Costs

Issuing a Letter of Credit may involve hefty fees. If exporters have to cover all the extra charges, the guarantee may not be worth it.

• The creditworthiness of the customer

Always review the customer’s track record with your business.

• Export Risks

It may be a good idea to receive a Letter of Credit when exporting to politically unstable countries and potentially unreliable trading partners.

• Standard trading practices

When transporting specific goods, the standard practice may involve using a Letter of Credit. In shipping, many buyers and sellers appreciate the extra assurance when dealing with high-value cargo.

• Available guidance

After assessing the trading circumstances, a bank may recommend a Letter of Credit as the optimal solution.

On the other hand, many credit insurers insist on using this document, regardless of the circumstances.

Exporters should carefully weigh all the pros and cons before making a final decision. Look into alternative options. Export factoring or credit insurance may be a better arrangement for your situation.

Letter of Credit: Advantages and Disadvantages

The procedure for Letter of Credit is complex, and the document significantly impacts buyers and sellers.

How Letter of Credit Works for Sellers

Letters of Credit are a standard solution for trading situations when buyers and sellers are based in different countries. They offer a high level of protection to exporters and transfer non-payment risks onto banks. However, they are only valid if the seller follows the strict rules established by the bank.

How Letter of Credit Works for Buyers

Buyers also benefit from a Letter of Credit. Requirements may vary, but the primary purpose is to assure the buyer that the seller will deliver the goods as agreed.

Note that using a Letter of Credit carries additional costs. The security benefits may not always justify the bank fees for small and mid-sized businesses.

Additionally, exporters won’t receive payment unless they honour all terms of the agreement. They must supply documentary proof that they’ve met every contract condition. Consequently, a Letter of Credit may cause unexpected delays and charges in international trade.

Letter of Credit: Uses

Let’s look at when buyers and sellers should opt for a Letter of Credit.

Letter of Credit: Uses for Buyers

As mentioned, using Letters of Credit could involve steep costs and delays. Experts advise that buyers consider applying for a Letter of Credit if required by the supplier or government exchange controls.

Letter of Credit: Uses for Sellers

A Letter of Credit benefits sellers when alternative arrangements aren’t suitable. You’ll have to decide which type to use if you determine that this document works best for your circumstances. In general, businesses should have an in-house policy regulating the use of Letters of Credit. Since they may discourage potential customers from trading with you, review the policy periodically to ensure it meets your needs.

What Is Letter of Credit With Example

Letters of Credit may fall into five subgroups and are consequently viewed as:

• Revocable
• Irrevocable
• Confirmed
• Unconfirmed
• Transferable

Additional types include:

• Back-to-back
• Standby
• Revolving

It’s not uncommon for a Letter of Credit to combine two subgroups.

Choosing a Letter of Credit: Advantages and Disadvantages

Not all types of Letters of Credit may fit your circumstances, so choose the most beneficial option for all parties.

How Letter of Credit Works: Revocable and Irrevocable

A bank has the right to modify or cancel a revocable Letter of Credit for any reason and at any time.

In contrast, it’s impossible to modify or cancel an irrevocable Letter of Credit without the agreement of all involved parties. This type provides more security than its revocable counterpart.

Using this type of letter of credit in shipping is generally discouraged as sellers and buyers have little control over the transaction.

How Letter of Credit Works: Confirmed and Unconfirmed

Banks frequently issue unconfirmed and confirmed Letters of Credit.

What Is Letter of Credit With Example: Unconfirmed

A buyer applies for a Letter of Credit at the bank of their choice, known as the issuing bank. Sellers usually ask banks in their countries to review the documentation and ensure the Letter of Credit is valid.

What Is Letter of Credit With Example: Confirmed

The seller’s bank may agree to “confirm” the Letter, meaning it takes on the risk of failed payment. Thus, if the issuing bank fails to transfer the funds to the seller’s account, the confirmation protects the seller from financial loss.

How Letter of Credit Works: Transferable

Bank issue transferable Letters when the transaction involves intermediaries. Large businesses use this type of letter of credit in shipping matters when working with multiple partners.

Everything You Need to Know About Using a Letter of Credit

The procedure for Letter of Credit often confuses businesses just entering the trading world. This document can be invaluable for sellers and buyers, but only under the appropriate circumstances. Those still unsure whether a Letter of Credit would secure their transactions should contact a reputable freight forwarder like GenX Freight for professional assistance.