Letter of Credit: What is it and How Does it Work?

2021-02-13

Shirley Zhao

The exchange of goods and services for capital is the bedrock of pretty much every consumer-focused industry. Whether selling your own product to customers or purchasing your inventory from a supply warehouse, a steady flow of capital and assets, and a reliable exchange method, is likely at the heart of your business’s success. 

There are a number of ways in which the exchange of capital for goods and services can play out, and some require more preparation and security than others. For example, a wholesale purchase of Japanese-manufactured car parts is a larger — and more risky — deal than an exchange with a local farmer for produce goods. In such a situation, where the sum of capital changing hands is large and the process of exchange is a complicated and lengthy process, suppliers of goods and services will often seek a letter of credit to assure the deal’s viability. A letter of credit, like other forms of securitized deals, can be a huge asset to your small business’s ability to execute growth initiatives and large-scale deals.

What is a Letter of Credit?

A letter of credit is a letter, written by a third-party bank, confirming that a seller of a good will receive payment from the buyer on time and in the correct amount. If the buyer fails to complete the payments on schedule, then the responsibility of compensation falls to the bank, which will then cover the cost to the seller.  In this scenario, the bank is acting to protect the interests of both parties; they protect the seller by ensuring that they will receive compensation, and the buyer by reducing the risk that a large purchase could drive their firm to insolvency. 

Typically, it is the buyer’s bank that issues a letter of credit for a deal in exchange for a service fee related to the size of the purchase in question. However, it is also possible that multiple banks must sign off on a letter of credit in order to legitimize a deal. This is especially common for the international trading sector and other large-scale transactional markets.

How Does a Letter of Credit Work?

A letter of credit can be a key tool for your small business, as it can make a huge difference in the ease of large-scale sales or purchases for both parties involved. 

Typically, a letter of credit is issued by the buyer’s bank. If your small business is selling goods to an overseas customer or partner, this means that you’ll likely be dealing with a foreign bank throughout this transaction. A letter of credit issued by a buyer’s bank in a different country can and should help clarify the rates of exchange and payment expectations for the foreign market with which you may not be familiar. 

Depending on the terms of your negotiations, a letter of credit issued by a buyer’s bank can come with a 90, 60, or 30 day term. This means that, as a seller, if you have not received payment for your goods or services in that span, the issuing bank will complete the transaction on the buyer’s behalf. 

If you’re familiar with real estate transactions, you might want to compare the use of a letter of credit to an escrow account. An escrow agent acts as a third party in property sales, holding the money and land titles being exchanged in temporary “safe-keeping” until the terms of the deal have been met and compensation can go forward. Somewhat similarly, the issuing bank of a letter of credit acts as mutual security for both parties, holding the necessary documents and capital in stock until the deal has been completed; if a deal is not completed, and the buyer defaults on their terms of purchase, the bank steps in to complete the deal.

Seller Protection

For a seller, the benefit of a letter of credit lies in the security it provides for a transaction. If your small business is selling on the foreign market for the first time, or interacting with new or unknown buyers, a letter of credit from the purchaser’s bank can ensure you won’t be hung out to dry when it comes time to receive payment. In this way, a letter of credit can be vital to your small business’s security in new dealings.

Buyer Protection

And if your small business is looking to purchase goods from an international supplier or new wholesale retailer, a letter of credit can provide important support for your role as a buyer. Not only are you offered a degree of protection from your bank in the case of a missed payment – in which case the bank would step in on your behalf and extract a service fee – but you may also receive assurance via a letter of credit that the selling party in a transaction will complete their end of things. Most letters of credit have provisions indicating that incomplete or insufficient service from the seller can trigger a (partial) refund for the buyer. A letter of credit, therefore, holds both parties responsible in complicated transactions.

When to Use a Letter of Credit

Despite the benefit of added security and accountability that a letter of credit brings, they are not often used in business transactions. For small businesses, the most common use of a letter of credit would be to assure a new or foreign supplier that you’ll be able to meet the terms of your negotiations. 

Conversely, you might ask for a letter of credit from a customer or client that is seeking a large or complicated purchase of your products. In these scenarios, in which there is a significant physical distance between the two parties, an exchange rate to navigate, and a complicated process of payment, a letter of credit can stabilize things on both sides.

Who is Involved in a Letter of Credit

One of the reasons why letters of credit are so rare in business dealings is that the process for seeking, obtaining, and executing a letter of credit is a long and many-sided ordeal involving numerous third party actors and institutions. Here are some of the common faces at play in a typical letter of credit negotiation.

Buyer

The buyer in a complicated or international transaction involving a letter of credit is also the applicant in the process. This means that, unless in special circumstances, the buyer is responsible for initiating the letter of credit, and it is their bank which takes responsibility for the negotiation.

Seller

The seller in these negotiations is also known as the beneficiary. This is the party which is fulfilling the request for a good or service, and which receives the payment either from the buyer or, in the case of a deal-break, the buyer’s bank.

Issuing Bank

The buyer’s bank is also known as the issuing bank for a letter of credit. Like other forms of financing, receiving a bank-signed letter of credit often involves an application process in which you must prove your business’s viability and creditworthiness to the bank before they agree to support your venture.

Negotiating Bank

In some instances, a negotiating bank will be called in to support the seller’s side of negotiations. This bank is located in the seller’s home country and is their personal representative in the deal in terms of determining the expected time frames and compensation rates of a deal.

Confirming Bank

The confirming bank in these scenarios is often the same entity as the negotiating bank. These figures help ensure that the seller receives their pay, one way or the other. In some cases, the confirming bank receives payment from the buyer or buyer’s bank and then forwards the funds to the seller. In others, the confirming bank simply acts as a negotiating partner for the seller, helping ensure that the financial aspects of the deal go smoothly.

Intermediary

An intermediary in these negotiations is a sort of go-between for both the buyer and seller. Often, an intermediary connects the two parties in the first place, and can help negotiate the terms of a letter of credit with mutual interest in both parties. An intermediary may be a representative of the seller’s bank, the buyer’s bank, or an independent third party entity.

Freight Forwarder

In the case of large international transactions of tangible goods, a freight forwarder is in charge of the physical transport of the assets in question. Beyond providing for shipping and handling of the goods, a freight forwarder helps handle the logistics of international trade such as postage and import fees or export fees.

Shipper

The shipper is in charge of actually transporting and delivering the goods, and may often work under the supervision of the freight forwarding company.

Legal Counsel

Legal counsel is often called into play in these negotiations in order to streamline the process for both sides and ensure that the dealing parties are on the same page. The scope of a legal counsel in these situations can range from simple contract oversight to dispute resolution in the case of default of malfeasance.

How to Get a Letter of Credit

If you find yourself on either end of a complicated business transaction, it may be in your best interest to pursue a letter of credit to ensure your receipt of payment or goods. To do so, the best place to begin is at your own bank. If you’re a buyer in this scenario, your bank will either issue the letter of credit on your behalf, or connect you with a larger financial institution that’s able to do so. If you’re the seller, your bank may be able to connect with a bank or financial institution in the buyer’s home country in order to consult on a deal and confirm the terms and conditions for either side. Letters of credit can be complicated processes, but they altogether can help to push along highly technical or risky transactions, providing added security for all parties involved. 

After having been issued a letter of credit, consider a line of credit when you’re in need of a flexible alternative financing solution.

Author:

Jeffrey Bumbales
Director, Marketing & Strategic Partnerships at Credibly