Terminology 101: Letters of Credit (LOCs)

Letters of credit (LOCs) are widely used in international trade to provide a guarantee to the seller that payment will be received for goods or services exported. They are essentially a promise from a bank to pay the seller once certain conditions are met.

Three of the Most Common Types of Letters of Credit

  1. Revocable LOCs: These LOCs can be amended or canceled by the issuing bank without the consent of the seller. This type of LOC is generally not used in export transactions due to the lack of security it provides to the seller.
  2. Irrevocable LOCs: These LOCs cannot be amended or canceled without the consent of all parties involved. This type of LOC is commonly used in export transactions as it provides greater security to the seller.
  3. Confirmed LOCs: These LOCs have an additional guarantee from a second bank, in addition to the issuing bank. This provides an extra layer of security to the seller, as they have the assurance of two banks rather than just one.

Advantages of Using a Letter of Credit in an Export Transaction

  • For the seller, a letter of credit provides a guarantee of payment and minimizes the risk of non-payment. It also ensures that the seller will receive payment in a timely manner, as the issuing bank is required to pay once the required conditions are met.
  • For the buyer, a letter of credit provides security and assurance that the seller will fulfill their part of the contract. It also allows the buyer to negotiate more favorable terms, as the issuing bank is responsible for ensuring that the required conditions are met.
  • There are also several benefits to using a letter of credit for the issuing bank. It allows the bank to manage their risk by only releasing payment once the required conditions are met. It can generate fee income for the bank through the issuance of the letter of credit and any amendments or extensions.

Disadvantages of Using a Letter of Credit in an Export Transaction

  • For the seller, it can be time-consuming and costly to comply with the requirements of the letter of credit, such as providing documentation or obtaining certifications. It is also important for the seller to carefully review the terms and conditions of the letter of credit to ensure that they are reasonable and achievable.
  • For the buyer, using a letter of credit may involve additional costs, such as the fees associated with obtaining and issuing the letter of credit. It is also important for the buyer to carefully review the terms and conditions of the letter of credit to ensure that they are consistent with the terms of the underlying contract.

In conclusion, letters of credit are a useful tool for managing risk and ensuring payment in export transactions. They provide a guarantee of payment to the seller and security to the buyer, and can be used in a variety of situations. However, it is important for both the seller and the buyer to carefully review the terms and conditions of the letter of credit and to consider any potential drawbacks before using this type of payment mechanism. Another great resource for information on LOCs is available at trade.gov.

To learn more about the processes and documents used in international trade, consider brushing up on the fundamentals by taking Dunlap-Stone University’s TRD-201 Exporting/Importing Environment or TRD-225 Documentation for the Global Village. Each six-week long online course can make sure you have the knowledge you need for successful transactions.