how a letter of credit works
buyers of major purchases may need a letter of credit to assure the seller that the payment will be made a bank issues a letter of credit to guarantee the payment to the seller essentially assuming the responsibility of ensuring the seller is paid a buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay before the bank will guarantee the payment to the seller 1banks typically require a pledge of securities or cash as collateral for issuing a letter of credit because a letter of credit is typically a negotiable instrument the issuing bank pays the beneficiary or any bank nominated by the beneficiary if a letter of credit is transferable the beneficiary may assign another entity such as a corporate parent or a third party the right to draw the international chamber of commerce s uniform customs and practice for documentary credits oversees letters of credit used in international transactions 2banks usually charge a fee for a letter of credit which can be a percentage of the total credit they are backing the cost of a letter of credit will vary by bank and the size of the letter of credit for example the bank may charge 0 75 of the amount that it s guaranteeing fees can also depend on the type of letter in an import export situation an unconfirmed letter of credit is less costly a confirmed letter of credit may have higher fees attached based on the issuing bank s credit strength 3types of letters of creditthe types of letters of credit include a commercial letter of credit a revolving letter of credit a traveler s letter of credit a confirmed letter of credit and a standby letter of credit international trade will also sometimes use an unsecured also called a red clause letter of credit this is a direct payment method in which the issuing bank makes the payments to the beneficiary in contrast a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot 4this kind of letter allows a customer to make any number of draws within a certain limit during a specific period it can be useful if there are frequent merchandise shipments for example and you don t want to redraft or edit letters of credit each time 5for those going abroad this letter will guarantee that issuing banks will honor drafts made at certain foreign banks 6a confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit the second bank is the confirming bank typically the seller s bank the confirming bank ensures payment under the letter of credit if the holder and the issuing bank default the issuing bank in international transactions typically requests this arrangement 3a standby letter of credit provides payment if something does not occur which is the opposite of how other types of letters of credit are structured 7 so instead of facilitating a transaction with funding a standby letter of credit is like an insurance contract it protects and compensates one party the beneficiary if the other party named in the agreement fails to perform the stated duty or meets certain service level agreements outlined in the letter of credit example of a letter of creditcitibank offers letters of credit for buyers in latin america africa eastern europe asia and the middle east who may have difficulty obtaining international credit on their own citibank s letters of credit help exporters minimize the importer s country risk and the issuing bank s commercial credit risk 8letters of credit are typically provided within two business days guaranteeing payment by the confirming citibank branch 9 this benefit is especially valuable when a client is located in a potentially unstable economic environment 