In simple terms, a Letter of Credit (LC) is a financial tool that guarantees payment to a beneficiary in a business transaction. As a business owner or corporate officer, you can request an LC from your bank, assuring the supplier or vendor that payment will be made. If you fail to meet this obligation, the bank pays the beneficiary directly. In some cases, the LC itself acts as the repayment vehicle, allowing the beneficiary to redeem it for immediate payment.
While historically useful for securing international and domestic trade, Letters of Credit are gradually becoming less common as alternative financing options emerge.
Steps Involved in Obtaining a Letter of Credit
To illustrate, suppose you want to purchase $75,000 worth of smartphones from a Japanese manufacturer. The manufacturer agrees to ship the products provided payment is made within 60 days. You might also be required to issue a 90-day LC for the full transaction amount. The process typically follows these steps:
1. Request the LC from Your Bank
You ask your bank to issue a $75,000 Letter of Credit naming the Japanese manufacturer as the beneficiary.
2. Bank Underwriting
The bank assumes a contingent liability on your behalf and extends credit to the beneficiary. If your company has a strong financial standing, the LC is issued.
3. Secured LCs for Small Businesses
If your company does not meet credit standards, you may still obtain an LC by providing cash collateral. This is common for smaller businesses.
4. Notification of the Beneficiary
Your bank sends the LC to the manufacturer’s bank, which notifies the supplier so shipment can proceed.
5. Payment Upon Shipment
Once the supplier provides proof of shipment, the LC can serve as the payment source. Fees for the LC typically range between 1.5% to 8% of the total value.
Types of Letters of Credit
Banks issue different LCs based on risk and flexibility needs:
- Revocable Letter of Credit – Can be canceled by the issuing bank without requiring the beneficiary’s consent.
- Irrevocable Letter of Credit – Cannot be altered or revoked without agreement from all parties.
- Standby Letter of Credit – Acts as a backup; the beneficiary can demand payment directly from the bank if the buyer fails to pay.
- Revolving Letter of Credit – Ideal for recurring shipments, eliminating the need for a new LC for each transaction.
Why Letters of Credit Are Becoming Less Popular
Despite their historical convenience, LCs are increasingly viewed as risky and inefficient. Key concerns include:
- Fraud Risk: Suppliers might deliver damaged, incomplete, or nonexistent goods, or even forge documentation.
- Legal and Political Risk: Government intervention or legal disputes can delay or block transactions.
- Business Disruption: Natural disasters, wars, or domestic conflicts can impact fulfillment.
- Financial Risk: The applicant or issuing bank may become insolvent, or the beneficiary may fail to deliver goods.
Because of these factors, many businesses now prefer more flexible and reliable trade financing solutions.
How Trade Payables Financing Is Replacing Letters of Credit
Modern alternatives like Trade Payables Financing and Supply Chain Financing are increasingly replacing traditional LC transactions. These solutions streamline payments and reduce risk for both buyers and suppliers.
Here’s how it works:
- The supplier submits invoices to the buyer.
- The buyer instructs a trade payable financing company to pay the invoice on the agreed date.
- Optional early payments can be arranged.
- Fees and terms are negotiated directly between the buyer and supplier, improving transparency and efficiency.
This approach ensures that suppliers receive timely payments while buyers can manage cash flow more effectively, making it a more practical solution in today’s global trade environment.
Final Thoughts
Letters of Credit have long been a cornerstone of international trade, providing assurance and reducing payment risk. However, in today’s dynamic financial landscape, they are gradually becoming obsolete. Alternative financing methods like Trade Payables Financing offer greater flexibility, lower risk, and more control over cash flow, making them the preferred choice for modern businesses.
