Questions and Answers About Letters of Credit

By Michael C. Dennis

Letters of Credit (LCs) are vital for smoothing out deals between buyers and sellers who might be miles apart and don't know each other well. This Q&A breaks down the basics and the finer points of how these financial tools work.

Q: What is the purpose of a Letter of Credit? A: The primary purpose is to reduce the risk of non-payment for the seller and non-delivery for the buyer in international trade.

Q: How does an LC transaction typically proceed? A: The buyer applies for an LC from their bank (issuing bank), which then sends it to the seller's bank (advising/confirming bank). The seller ships the goods and presents the required documents. If the documents comply, the issuing bank pays the seller.

Q: What is a "sight LC"? A: A sight LC requires immediate payment upon presentation of compliant documents.

Q: What is a "deferred payment LC"? A: A deferred payment LC allows for payment at a later date, as specified in the LC.

Q: What is a "red clause LC"? A: A red clause LC allows the seller to receive an advance payment before shipment, typically to finance production.

Q: What is a "transferable LC"? A: A transferable LC allows the seller to transfer their rights to another beneficiary.

Q: What is a "revolving LC"? A: A revolving LC is automatically reinstated after each utilization, allowing for multiple shipments under the same LC.

Q: What are the risks associated with LCs? A: Discrepancies in documents, bank insolvency, and fraud are potential risks.

Q: How can discrepancies be avoided? A: Meticulous attention to detail, clear and precise LC terms, and thorough document review are essential.

Q: What is the role of SWIFT in LC transactions? A: SWIFT (Society for Worldwide Interbank Financial Telecommunication) is used for secure communication and transmission of LC messages between banks.

Q: What are the costs associated with LCs? A: Issuing fees, advising fees, confirmation fees, and discrepancy fees are common costs.

Q: What is the validity period of an LC? A: The validity period specifies the time frame within which the documents must be presented for payment.

Q: What is the "nominated bank"? A: The nominated bank is the bank authorized to receive and examine documents under the LC.

Q: How are LCs regulated internationally? A: The UCP 600, published by the ICC, provides the standardized rules and practices for documentary credits.

Q: What are the benefits of using an LC for the buyer? A: Ensures goods are shipped as specified, prevents payment before shipment, and provides a structured payment process.

Q: What are the benefits of using an LC for the seller? A: Guarantees payment upon compliance, reduces credit risk, and provides access to financing.

Q: What is a silent confirmation in an LC? A: This is when a bank confirms an LC without the issuing banks knowledge.

Q: What is a back-to-back LC? A: One LC is used as collateral to open a second LC. This is often used with middlemen in a transaction.

Q: What is an assignment of proceeds? A: This allows the beneficiary to assign the proceeds of the LC to another party.

Q: What are the responsibilities of the issuing bank? A: The issuing bank must honor compliant presentations and ensure accurate LC issuance.

Q: How do digital LCs change the process? A: Digital LCs streamline document processing, reduce costs, and increase efficiency through electronic platforms.

As global trade continues to evolve, the LC remains a vital instrument, adapting to new technologies and challenges, ensuring a secure and efficient flow of commerce across borders.

Thank you for exploring the world of Letters of Credit with me.