What is a Letter of Credit (LC)? How is Payment Security Ensured in Foreign Trade?

A letter of credit (LC) is a payment method where the buyer's bank guarantees payment to the seller upon presentation of specific documents (invoice, bill of lading, insurance policy, etc.). Because it provides security for both the seller (guaranteeing payment) and the buyer (providing documented proof that the goods were shipped according to the specified conditions), letters of credit are preferred, especially in newly established business relationships.

How does a letter of credit work?

1. Contract : The buyer and seller agree on payment by letter of credit.
2. Opening a letter of credit : The buyer's bank (issuing bank) opens the letter of credit to the seller's bank (beneficiary bank).
3. Shipment : The seller ships the goods and prepares the documents required in the letter of credit (invoice, bill of lading, insurance policy, certificate of origin, etc.).
4. Document submission : The seller submits the documents to their bank; the bank examines the documents for compliance with the letter of credit terms.
5. Payment : If the documents are found to be satisfactory, the issuing bank will make the payment.

Types of Letters of Credit

• Irrevocable Letter of Credit (LC) : Cannot be changed or canceled without the consent of all parties; it is the most commonly used type.
• Confirmed Letter of Credit (LC) : A second bank (usually a bank in the seller's country) also confirms the payment commitment, providing additional security for the seller.
• Revolving Letter of Credit : In regular/recurring orders, instead of opening a new letter of credit each time, it is automatically renewed for a predetermined amount.

Advantages and Considerations Regarding Letters of Credit

Advantages:

• It provides payment security for the seller.
• For the buyer, it guarantees that payment will only be made when the correct documents are submitted.

Things to keep in mind:

• Bank fees may be higher compared to other payment methods.
• Minor discrepancies in documents (e.g., date or amount errors) can lead to payment delays.
• The process may take longer compared to methods like upfront payment or bank transfer.

Frequently Asked Questions

In what situations should a letter of credit be preferred? Letters of credit are particularly preferred in newly established business relationships where mutual trust has not yet been built, or in high-value transactions.

What is the difference between a letter of credit and cash payment? In cash payment, the buyer makes the payment before seeing the goods; in a letter of credit, payment is contingent upon presentation of specified documents, and banks secure the process.

Who pays the letter of credit fees? Generally, the party opening the letter of credit (the buyer) covers the bank charges; however, this can be specified differently by contract between the parties.

Will payment be withheld if there is a minor error in the documents? Banks evaluate documents for strict compliance with the letter of credit terms; if discrepancies are found, payment may be delayed or additional confirmation may be required.

Is using letters of credit difficult for SMEs? The process may seem complicated at first glance, but banks and foreign trade experts can support companies in preparing and following up on documents.

This content was prepared by the GoTradeGo team. If you would like to receive support from an international trade expert regarding the letter of credit process or payment security, you can access the relevant profiles on gotradego.com .