Letter of Credit

A Letter of Credit [LC] is a way of funding purchases when the seller is reluctant to despatch the goods unless they have been paid for and the buyer is reluctant to pay unless they have received the goods. To overcome a potential impasse, Letters of Credit allow banks to manage the buyer and supplier’s risk by creating a documentary chain. The buyer’s bank sends a Letter of Credit to the supplier, which triggers despatch of the goods to the carrier. The buyer’s bank also arranges to pay the seller’s bank, on presentation of evidence the goods have been shipped, such as a Bill of Lading. When the supplier presents the Bill of Lading to their own bank, their own bank pays them, if the details match. The Bill of Lading is then presented to the buyer’s bank by the supplier’s bank, and the buyer’s bank debits the amount from the buyer’s account. The buyer uses the Bill of Lading to take delivery of the goods from the carrier. Used primarily in international trade transactions of significant value, Letters of Credit are complex instruments and some transactions fail, as the documents do not match exactly, so parties may prefer to arrange a normal commercial invoice once trust has been created in the relationship. See also Bill of Lading.