A letter of credit, or LC, is a legal document used in international trade. Issued by the bank on behalf of the buyer to the seller, it promises to pay the invoice value. However, the seller has to meet certain conditions and has to submit the required documents. The document provides confidence to the seller that the payment will be made and benefits the buyer with higher bargaining power with the bank as an intermediary.
LC also provides protection to the buyer, as payment will be made only after the seller submits essential documents regarding the trade. This payment method is selected when the buyer and seller don’t have a long business relationship for international trade.
How It Works:
- Buyer requests the bank to issue a Letter of Credit.
- The bank guarantees payment to the seller.
- The seller ships goods as per agreed terms.
- Required documents are submitted to the bank.
- Payment is released after verification.
Benefits:
- Reduces payment risk in international trade
- Ensures timely payment to the seller
- Builds trust between buyer and seller
- Facilitates global transactions
Example:
An Indian importer buys machinery from a supplier in Germany using an LC. The German supplier ships the machinery and submits the required documents to the bank, which then releases the payment.