Letter of Credit

How will you ensure get timely payment against your business transaction? Have you ever considered the possibility of facing payment delays or getting scammed by someone you have never worked with before?

Online trading is full of risks, and often vendors face consequences of the unplanned payment procedure. Although a contract between seller and buyer is good enough to establish trust, arranging a protective measure to secure payment is better.

For this purpose, a Letter of Credit is considered a viable solution to protect both sellers and buyers from a third party. What is LOC? How does it work? How can it help your business prevent significant risks? To survive and thrive in your business, it is imperative to learn about LOC. Therefore, here we have brought an ultimate guide to a Letter of Credit in 2023.

So without any further delay, let’s get straight into it.

Chapter 1. An Overview of Letter of Credit

In every business, receiving timely payment in full is the ultimate concern, whether you’re dealing with a domestic or international customer. For that reason, both seller and buyer fulfill legal obligations like making a contract to avoid inconveniences.

The contract mentions all the terms and conditions to make sure both parties are on the same page. A contract is enforceable by law and imposes serious penalties upon violation. While a contract helps a business do genuine trading, a Letter of Credit works as insurance to protect your payment.

It’s a guarantee by a third party that your customer will pay you on time. It secures your payment and prevents your business from facing future inconveniences.

In this Chapter, we’ll discuss the following insight mechanism to give you an in-depth review. Check it out!

1) What is a Letter of Credit?

What is a Letter of Credit

LOC is a credit letter issued by a third party, usually a financial institution or bank, to protect payment between parties. It underlies a responsibility to pay the remainder in case of non-payment by the LOC purchaser (customer). LOC works as an impartial party and monitors the payment operations in a trade.

LOC is commonly involved in international trade where both parties are unknown to each other. Or if a business is trading with a new customer, it requires a guarantee that the payment will be made in full and on time. China is the largest wholesale supply chain country in the world, and thousands of businesses trade with it. The only reason traders are satisfied with Chinese vendors is because of LOC.

For both importers and exporters, it is the most effective financial instrument to flow cash and goods as safely as possible.

2) Parties of LOC

Parties of LOC

Apparently, 3 persons seem to be a party of LOC, a seller, a buyer, and a third party. However, there are 7 parties involved in a LOC. Let’s define them briefly.

a) Applicant

The applicant is the main party of LOC. An applicant is a person on whom request the bank issues LOC. An applicant is commonly the buyer of goods, and he opens the credit letter with his bank in favor of the seller.

He gives all the payment details, including modes of payment, in total/installments, and time. Similarly, the credit letter is issued as per the settled negotiations.

b) Issuing Institute

The next party to LOC is issuing institute or the bank that drafts the letter. The bank takes the responsibility to pay the beneficiary if the customer fails to do so. However, the issuing institute requires some security from the purchaser to draft a credit letter, just like we take a loan from a bank.

c) Beneficiary

The third main party is the vendor or the seller from whom the buyer purchased goods. A beneficiary party is entitled to receive payment according to the credit letter. To receive payment via a letter of credit, the beneficiary has to submit some documents in accordance with their bank.

d) Advisory Bank

Here is the next party to credit letter. An advisory bank is involved in forming communication with all the parties of the credit letter. They are responsible for sending documents to the opening bank and communicating with other relevant authorities.

e) Confirming Bank

After thoroughly examining the relevant documents and accepting the payment responsibility, the confirming bank caters to everything. It looks all inside and accepts the negotiation.

f) Negotiating Institute

The next party we have in LOC is negotiating institute. It takes all the required documents, verifies them, and then confirms the negotiations on behalf of the beneficiary.

g) Reimbursing Bank

Here is the 7th party to credit letter. The duty of this party is to authorize the reimbursement claim.

3) How Does a Letter of Credit Work?

How Does a Letter of Credit Work?

Obtaining a credit letter for business does require some insight and knowledge. The whole operation gets started when a buyer and seller have a transactional need or, similarly, if they are doing business for the first time. In that situation, businesses are concerned with protected transactions for which a letter of credit helps.

The financial institution issues this letter, which is usually made at the purchaser’s request (customer who bought goods). Specific bank branches like commercial divisions and international trade departments exist in international trade. However, the issuing bank requires security to keep the credit letter secure.

Obtaining a LOC is like applying for a loan; the applicant must partner with a lender. After arranging security, the bank requires documents like,

  • Business contract
  • Purchase agreement
  • Payment amount
  • Import/export contract
  • Settled amount

Apart from documents, credit letters cost a fee which is often a percentage of the amount against the letter. This fee is levitated on the purchaser, and once the formalities are done, the letter is sent to the beneficiary.

One of the best things about LOC is establishing trust between parties immediately. Both the seller and buyer now have peace. The payment is guaranteed.

4) When to Use LOC?

Now here comes the question, when to use LOC? How would a business know the right time to use a credit letter? Let’s illustrate this with an example.

A common scenario would be a company collaborating with a company in another country in an international trade deal. Assume an exporter (the seller) in the United States wishes to collaborate with an importer (the buyer) in another country.

The two companies decide to collaborate and reach an agreement on transaction terms such as price, timeline, and delivery date. To ensure that the transaction is completed in full, the seller requests a letter of credit from the buyer. No matter what happens with the other party’s finances, the buyer obtaining the letter of credit can help put the seller at ease in the deal, especially if they’ve never worked with the buyer before.

A commercial lease is another common scenario. Assume a tenant and a landlord agree on the terms of a commercial lease, including the monthly payment. In this case, the landlord could request that the tenant obtain a letter of credit to ensure that rent payments are covered if the tenant cannot pay.

Chapter 2. What are the Types of Letters of Credit?

types of letter of credit

As we discussed in the previous chapter, a letter of credit helps in smoothing an international business transaction. Not only it secures payment but helps in creating trust between parties. Primarily, a business is always concerned about generating immense revenue, which is possible in an e-commerce venture.

While e-commerce allows businesses to make huge money, it also comes with significant risks. Nobody wants to end up getting ghosted by a customer after delivering goods.

So how can a business prevent that from happening? The answer is a letter of credit.

However, this is not it!

When it comes to the letter of credit, there are several types available. Considering various possible factors, credit letters are categorized into specific roles. And it is imperative to know which credit letter is viable for you. Therefore, this chapter will explore different types of credit letters to help you know which one to choose. So let’s get straight into it.

1) Commercial Letter of Credit

The first credit letter on our list is a commercial letter of credit. Commercial credit letters are the standard letters issued by a bank or financial institution. For international trade, the parties commonly use a neutral third party like any international bank or sub-division.

Bank issues a credit letter at the request of a purchaser (customer for goods).

In return, the customer provides all the mandatory details and documents, including the settled price, purchase agreement, and import/export authorization. As soon as the purchaser provides all the formal documents and details, the bank issues a commercial credit letter. It acts as a neutral party and releases all the payments once parties meet the terms and conditions of the agreement.

2) Standby Credit Letters

Standby Credit Letters

The next type we have on our list is standby credit letters. Standby credit letters are similar to commercial letters but compensate the payee when something goes wrong.

In standby letters, the issuing institute or bank releases the funds to the beneficiary if they are satisfied that the parties did not meet the conditions. The payee has to submit specific proof, either documentary or circumstantial, that the purchaser failed to pay the settled amount.

One of the key differences between a standby and a commercial credit letter is that standby is not the primary payment method.

It functions as compensation if the purchaser fails to comply with the conditions. Contrary to this, a commercial credit letter releases the fund when the beneficiary delivers goods, and the purchaser acknowledges it.

3) Confirmed/Credit Letters

As we all know, the purchaser creates a letter of credit with his bank at the beneficiary’s request. The bank undertakes to accommodate the beneficiary if the purchaser fails to do so. However, the beneficiary, on the other hand, isn’t familiar with the importer’s bank and cannot trust in that regard.

Consequently, the beneficiary needs assurance that the payment will ever arrive. Hence, the exporter must trust a bank in his hometown to represent on his behalf and compensate him if the purchaser’s bank lacks confidence.

Once the letter of credit is confirmed, the exporter contacts his bank to meet all requirements. Because of this, the exporter’s bank becomes liable to indemnify the beneficiary if the issuing bank fails to compensate.

4) Red Clause Credit Letter

A red clause letter of credit is a type of letter of credit in which a buyer provides a seller with an unsecured loan. Red Clause Letters of Credit allow beneficiaries of a documentary credit to receive funds for any merchandise specified in the letter of credit.

Beneficiaries who act as purchasing agents for buyers in another country frequently use these letters.

A red clause letter of credit enables an exporter to obtain pre-shipment financing, though available credit is typically limited to a portion of the estimated value. It could even be the entire purchase price.

A red clause letter of credit allows buyers to diversify their supply sources. Most buyers are hesitant to finance goods that have yet to be shipped. Still, an exporter and a buyer can be linked together through a standard contract with the trade bank establishing the red clause letter of credit against a registered contract with an approved buyer.

5) Back-to-Back Credit Letters

Back-to-Back Credit Letters

Are you trading business via an intermediary party like a broker or agent? In that case, back to back credit letter is the viable option for you. This type of credit letter is empowered by two distinct LOCs for the intermediary party.

For example, you are selling goods via a broker who further sells them to the principal purchaser. In that case, you become the beneficiary of the broker, and the broker becomes the beneficiary of the purchaser.

The purchaser will issue a credit letter with his bank in the broker’s name, and similarly, the broker will issue a letter in your name. Back-to-back credit letters are a powerful way of smoothening long-route business transactions and securing all the parties involved.

6) Sight Credit Letter

Sight Credit Letter

If your business transaction payment has some time to arrive, then a sight credit letter can help you immediately. It’s a document that releases the funds once the mentioned price is confirmed.

However, the beneficiary must provide sufficient documents like the purchase contract, the price settled, and delivery time very.

The bank can pay the beneficiary upon its satisfaction, which usually takes 5 business days. It generally involves three parties; the seller, the buyer, and the bank.

As the name suggests, at first sight, the bank instantly awards a proportion of protection to all the parties. This helps a business do hassle-free trading and becomes a viable option for instant recovery.

7) Deferred Letter of Credit

Deferred Letter of Credit

Not all credit letters are made to secure sellers only; here is something any buyer would love. A deferred letter of credit is similar to a sight letter; however, it does not clear all the payments at once. This letter releases a portion of the amount upon receiving the documents. This gives sufficient time for a buyer to find the seller’s fault.

In any business, responsibilities are equal at both ends. While the buyer is obligated to pay the settled amount, the seller must also meet the conditions discussed.

For instance, under-quality products and late deliveries could be the justification for not releasing payment on time. Hence, a deferred credit letter allows the buyer to find the seller’s fault.

8) Revolving Credit Letters

Revolving Credit Letters

Credit letters are a protective measure to secure large-scale trading; however, it’s a complex and time-consuming procedure. Importers/exporters require quick and long-term insurance to ensure their business is always protected.

If you want to do business with a particular customer repeatedly, you need a fresh credit letter every time, which is both time and energy-consuming.

For this purpose, revolving credit letters are considered a viable choice for parties. Revolving credit letters can be used multiple times until it gets expired. It frees businesses from drafting new credit letters every time and allows them to use the existing ones numerous times.

If it is expected to do multiple business transactions with a particular customer, it is better to issue a revolving credit letter.

Having a letter of credit in hand could prevent your business from facing severe losses, but having the right credit letter is better for practically securing your transaction. The credit mentioned above has various practical approaches, so make sure to select the suitable one.

Chapter 3. Why Should Businesses Get Letters of Credit?

Letter of Credit

Making an international business transaction seems fun and exciting until you know it could cause your business to suffer miserably. In international trade, ineffective communication is always on the rise.

Both sellers and buyers must ensure they are on the same page and meeting conditions effectively. But in most cases, neither of the party lacks its duties, among which payment clearance is the most frequent.

Obviously, international trade is a large-scale business involving significant risks; therefore, business owners must arrange protective measures to prevent mishaps. Speaking of protective measures, a letter of credit is known as the most effective way of securing online business.

There is much more to discuss about the importance of credit letters in business. So let’s get started!

1) It Secures Your Business Transaction

Secures Business Transaction

The first and the most dynamic reason to use a credit letter is that it secures your business transaction. Online business is a lucrative venture, allowing retailers to earn huge profits. It enables your business to sell products worldwide and grow massively.

While the international trading idea looks great, it comes with some risks. As clients present online are unknown and belong to different countries, it becomes very hard to establish trust. Therefore, the business requires assurance to receive timely payment in full. Hence, trusting a third-party instrument (letter of credit) helps you overcome risks.

2) Helps Establish Trust

two men are shaking hands

Trust is an integral part of every business; both the supplier and purchaser should be capable of trusting each other, and credit letters help you do that. As we all know, a credit letter guarantees the seller that he shall pay the amount after receiving the requested goods, but at the same time, it helps him prove his solvency.

Once the credit letter is issued, the buyer will immediately win the seller’s trust. It instantly declares both parties genuine, which helps your business go long way with the customer.

Similarly, a credit letter gives the buyer an opportunity to order instant supplies for a tight schedule. Buyers can wait to pay the whole amount immediately and can demand goods by issuing LOC as proof of future payment.

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3) Customizable

Every business operates on different terms, which are very important to mention while making a deal. Hence, a credit letter allows you to personalize the terms and conditions as preferred. Both parties can mutually negotiate and discuss the contents of the credit letter.

You can customize the negotiated time, price, time, date of delivering goods, and installment plan (if settled).

Once the contents are settled successfully, the issuing bank becomes responsible for paying on behalf of the purchaser. Along with customizable characters, credit letters have various types, including

  • Commercial LC
  • Revocable LC
  • Irrevocable LC
  • Red Clause LC

4) Consistent Cash Flow

Cash Flow

Here is another reason to get a credit letter in business; it helps you make consistent cash flow. In international trade, payment arrival often gets delayed due to the time lag of delivering goods. Meanwhile, it affects the business to manage cash flow and books of accounts. This ultimately creates a demand for receiving timely payments that are possible with credit letters only.

Furthermore, a business can get finances during the shipment and receiving payment, which gives an additional boost. So having a credit letter gives you so many leverages in multiple ways. That’s why credit letters are considered the best financial instrument for international trade.

5) Quick

The reason why e-commerce is considered lucrative worldwide is because of its fast process nature. Both sellers and buyers come to an agreement without the need for physical visitation. Vendors ship the goods, buyers pay the price, and vice versa. It all happens very quickly, so the protective measure must be as efficient as the business itself.

Considering the fast-paced online business ventures, banks have now made it possible for customers to get credit letters online. A purchaser can get it via the bank’s official website and fill out the digital forms promptly, and the letter will be prepared within 24 hrs.

This has made it more accessible for sellers and buyers belonging to different countries, and the issuing institute can get both parties on board online and enable them to view the credit letter.

6) Helpful in Disputable Transactions

Dispute in a group

Have you ever considered facing a customer dispute while the goods are on their way? For a seller, it’s the worst nightmare to have a disputable transaction. You realize your payment is in trouble, cash flow will become inconsistent, and your stock will be gone. You might have to file a suit against the purchaser, but it’s time-consuming.

Contrary to this, having a credit letter in hand will save you from facing this situation. A seller can withdraw funds from a credit letter in a disputable transaction.

The issuing bank allows you to get the payment even if things are upset between you and your buyer. The importer cannot hold the funds and resolve the dispute later in court. This protects a business from severe fraudulent transactions big time.

7) Professional Gesture

To survive and thrive in the saturated online market, a business has to think out of the box. With the rising competition globally in the e-commerce market, businesses need to retain and maintain goodwill. Here credit letters help you achieve the goal efficiently; it not only keeps your transaction safe but helps you leave professional gestures on buyers.

This shows your seriousness toward professionalism, which is beneficial for both businesses and buyers.

So these are some of the reasons why businesses must involve a credit letter in international trade. The market is getting saturated, so it’s imperative to gain customers’ trust.

In this way, a business can hook a large number of customers because there are buyers who are trading for the first time. Hence, this safe-play policy will be a huge persuasive factor in winning them. Hope this would’ve been proved helpful.

Also read on: What is the Letter of Indemnity?

Chapter 4. Legal Requisites to Import/Export in China

legal issues

China is the biggest manufacturing country worldwide and has an integral role in the production sector of thousands of businesses. It enables thousands of vendors to import/export products all over the world and helps them earn a significant margin.

However, it is not easy to deal with in China as the vendors have to comply with the legal regulations strictly.

There are goods in China that are categorized as permitted, restricted, and prohibited.

While it is essential for businesses to conduct market research, it is equally imperative to look after the legal aspects. Any business would only like their goods to be stuck at Chinese customs because of ignorance of the law.

However, ignorance of the law is no excuse; hence in this chapter, we will discuss all the legal requisites to import/export in China. So without any further delay, let’s get straight into it.

1) Import License

Let’s start the discussion with the import sector. China has very few imports as they are the biggest exporter in the world. So when it comes to importing, vendors must go through a formal process.

Generally, an importer has to obtain a license to import. Considering permitted and restricted goods, there are two types of import licenses.

  • Permitted Goods: Automatic License
  • Restricted Goods: Non-Automatic License
a) Permitted Goods: Automatic License

Permitted

Permitted goods are easy to import in China, and an automatic import license is issued for it. An automatic import license is valid for up to 6 months; hence the importer can make multiple transactions on it. But limited transactions are allowed for some goods and usually cover up to 6 batches. Therefore, it is better to apply for multiple licenses at once.

To obtain an automatic import license, the importer has to apply to the Ministry of Commerce (MOFCOM) before 2 weeks of custom clearance. It is also important to note that there are some goods that require additional monitoring for which the importer has to obtain a special license.

b)  Restricted Goods: Non-Automatic License

Restricted products

There are some goods that are restricted to import in China, but with a non-automatic license, it is possible. A non-automatic license is rarely issued in special cases, as restricted goods are subject to threats to national security. Therefore, a vendor must obtain a non-automatic license to import such goods.

It is valid for up to 6 months, and the importer is in charge of obtaining it through MOFCOM.

2) Export License

Export License

Now the chapter turns to the export side of China. As we all know, China is the leading exporting country in the world and is considered the backbone of the world’s e-commerce market. Exporting goods from China does require a license.

China won’t let you ship goods until you possess an export license, and before you obtain an export license, you have to fulfill the following conditions,

  • That your company registered as FTC (Foreign Trading Company)
  • Ministry of Commerce recognizes you as an exporter
  • You have applied for the license

Once you successfully fulfill the conditions, you can obtain an export license. Typically there are two types of export licenses as follows.

  • General Export License
  • Here we have the first type of export license,

In this instance, the license is suitable for any business-related transaction for a period of six months. Therefore, the exporter can submit a new license application each time he exports. Small manufacturers in China frequently lack general export licenses, so they frequently rely on FTCs with licenses to export goods on their behalf.

a)  Special Export License

A special export license is required to export restricted goods. There are some goods that require special permission to ship to other countries; therefore, the exporter has to apply for a special export license. It is usually valid for up to 6 months and requires to be authorized by MOFCOM.

b) Documents Required for Shipping

Documents

Document inspection is an imperative factor for trading in China. Whether you are an importer or exporter, you’re required to provide the following documents effectively,

  • Purchase contract
  • Invoice
  • Insurance policy
  • Letter of credit
  • Import license
  • Export license
  • Customs declaration
  • Shipping list
  • Inspection certificate
  • Your registered FTC certificate

These are the documents required to ship goods in/out of China; however, modifications are expected to make sure to check the current scenario before shipping goods.

3) Certificates and Standard

The China National Certification and Accreditation Administration are in charge of handling this situation in China (CNCA). The CNCA for some products has established different standards and certifications before they can be sold in China.

The China Compulsory Certificate is one of them (CCC, or 3C). An official list determines which products must pass certification before being imported, sold, or used in China. The products in question are primarily technical goods.

Additionally, you should be aware that there are additional Chinese standards, such as those for food, medicine, and cosmetics. International standards and requirements for industry-specific labeling frequently diverge from one another and can change frequently. As a result, you should visit the CNCA website and check it frequently for updates.

Chapter 5. FAQs about Letter of Credit

FAQs

1) Where to get a letter of credit?

A letter of credit is often issued by the buyer’s bank, which is usually an international-scale bank or sub-division. You can contact the bank and apply for the LOC quickly.

2) How long does it take to issue a credit letter?

Since the process has been modified with the help of technology, a credit letter is now issued within 24 hours.

3) What documents are required for a credit letter?

The applicant has to provide the following documents

  • Purchase contract
  • Commercial invoice
  • Insurance certificate
  • Inspection certificate
  • Freight mode
  • Time settled

4) Who pays for the letter of credit?

The applicant pays all the issuing charges, reimbursements, and covering negotiations incurred on credit letters. The applicant is usually the buyer who applies for a credit letter at the seller’s request.

5) What is the maximum period for a letter of credit?

The foreign buyer may request a credit period of 30, 60, 90, 120, or more days. However, following government regulations, the total credit period should be at most 180 days.

Conclusion

A credit letter is the most potent instrument to secure huge business transactions. It helps you cover your losses and enables you to do business with a particular client in the future.

This blog has covered everything a business needs to learn about the letter of credit. Once you successfully issue a credit letter, there’s no way you will face any trouble in international trade.

Similarly, it is essential to note all the legal requisites discussed above. Make sure you get all the documents before shipping goods because it’s a nightmare for vendors to have their goods stuck in customs.

We hope our blog has helped you find a reliable way to make it through the international market. For any further assistance, you can reach out to us anytime free of cost. We would be glad to help you out.