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What is a letter of credit?

A letter of credit (L/C) is an instrument used by a bank whereby the bank guarantees the capability of a buyer or an importer for a payment.


In international trade, both a buyer and a seller may have no trust in each other, where the former may worry that the latter will not arrange delivery of goods subject to the terms and conditions of their contract after an advancement is paid, while the latter may worry that the former will not make the full payment after the goods have been delivered or the shipping document has been presented.


Accordingly, two banks can act as the guarantors for both the buyer and seller to receive payments and present a document on behalf of one party in order to substitute the bank credit for the commercial credit. The instrument the bank uses for this activity is a L/C.


Clearly, a L/C is a certificate that guarantees the conditional payment and has long been a common method of settling accounts. Subject to the general provisions of such a method of settling accounts, the buyer shall deposit the payment into the bank which will issue a L/C and inform the distant bank (in which the seller opens an account) to notify the seller about such a payment. The seller will deliver the goods in accordance with terms and conditions specified in the contract and the L/C and obtain the payment from the bank on behalf of the buyer.


The L/C method has three features:


1. Since a L/C is not dependent on a sales contract, the bank focuses on the certification in a written form where the L/C is separated from the fundamental trade.


2. As the L/C method is the payment against a document and not based upon the goods, the issuing bank shall make the conditional payment as long as the document is in compliance with the specified conditions within the L/C.


3. An L/C is, as a kind of bank credit, the guaranteeing document issued by the bank.