Post 8: What is Letter of Credit?

A businessman named Raushan from Mumbai, wants to buy goods from Michael from New York. But, neither party trust each other, What if Raushan doesn’t pay after receiving the goods or what if Raushan pays first but Michael doesn’t deliver the goods, How do they proceed?

The above mentioned dilemma is a common business problem, so how do two parties who don’t trust each other but need each other’s goods do business? This is where “Letter Of Credit” comes into picture.

Let’s go back to the example of Raushan and Michael. Now, in order to proceed, Raushan will go to his bank in Mumbai, let’s say Standard Chartered Bank. SCB will examine all the necessary details of the transaction and write a letter of credit.

A letter of credit is a document, assuring Michael, that he will receive payment up to the amount of the letter of credit, as long as certain documentary delivery conditions have been met. In the event that Raushan is unable to make payment on the purchase, Michael may make a demand for payment on SCB. SCB will examine Michael’s demand and if it complies with the terms of the letter of credit, will honor the demand.


Real World Application:

Letters of Credit are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating in different countries. In this case the seller is exposed to a number of risks such as credit risk, and legal risk caused by the distance, differing laws and difficulty in knowing each party personally. A letter of credit provides the seller with a guarantee that they will get paid as long as certain documentary delivery conditions have been met. For this reason the use of letters of credit has become a very important aspect of international trade.

The bank that writes the letter of credit will act on behalf of the buyer and make sure that all documentary conditions have been met before making the payment to the seller. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. The current version, UCP600, became effective July 1, 2007. Letters of credit are typically used by importing and exporting companies particularly for large purchases and will often negate the need by the buyer to pay a deposit before delivery is made. They can also be used otherwise.

Read on and Suave It Mate!

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“What is Letter Of Credit?” by Ayush Agrawal is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.
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