A letter of credit is a bank obligation that a specific sum shall be paid to the supplier of goods or services on the condition that stipulated documentation evidencing the shipment of goods or the performance of the service is presented on a timely basis. More concisely, a letter of credit is a conditional bank guarantee.
In international trade, parties feel a mutual distrust and are exposed to risks as they do not know each other that well and every country applies different foreign currency regimes. The supplier wishes to collect the price of goods sold by it whereas the buyer is eager to take the delivery of those goods agreed in the contract on such agreed dates. Unless the seller acts in accordance with the terms of the letter of credit, the bank will in no event make a payment. This represents an assurance for the buyer. In the light of this, the letter of credit is a payment type which offers the highest level of assurance for both parties. If the terms of letter of credit stipulate that the payment will be done at a specific time after the shipment of goods, then the said transaction is called “term letter of credit”.
For the buyer:
• The bank does not make payment to a seller who defaults in fulfilling its obligations. This is an assurance for the buyer.
• The letter of credit causes goods to be shipped in line with the contract terms and on the due date.
For the seller:
• The seller undertakes to make the payment as soon as it presents the documentation designated in the letter of credit.
• It offers convenience to the seller in financing its purchases.
In short, where goods are shipped and the documentation is prepared in accordance with the terms of the letter of credit and the rules of international trade, the payment is the strict commitment of the bank which opens the letter of credit.