Irrevocable Letter of Credit (ILOC) is an agreement between a buyer and a seller that both parties agree to honor with the establishment of an irrevocable letter of credit. An ILOC is a legally binding financing mechanism that is used to secure payment from the customer in the event that the customer fails to meet its obligations. This document acts as an assurance for a business transaction by placing the customer’s funds into an account with the issuing financial institution.

When a company, typically an international trader, purchases goods from a foreign supplier, there is always a risk of the supplier not honoring the promise to deliver the goods. To protect itself, the company can arrange for an ILOC from their own bank. This will guarantee payment from the customer’s bank to the supplier’s bank if the customer fails to fulfill their obligations to the supplier.

The way that an ILOC works is that the buyer’s bank will issue the irrevocable letter of credit, paying the exporter only upon presentation of valid documentary evidence that the terms and conditions of the sale contract have been met. In addition, the exporter’s bank may also act as a confirming bank, guaranteeing the payment to the exporter even if the buyer’s bank does not pay.

The seller is not released from their contractual obligation to provide the goods as specified until all of the documents as outlined in the ILOC are presented by the buyer to the seller’s bank. These documents would typically include commercial invoices, an airway bill, and a certificate of origin stating where the goods originated. Once these documents are presented, the buyer’s bank pays the exporter, who in turn releases the goods to the buyer.

In addition to providing security, ILOCs also offer other advantages such as cost savings, speed, convenience, and flexibility. For example, an ILOC can help reduce transaction costs by eliminating the need for a third party to act as guarantor or as an intermediary between the buyer and the seller. Additionally, an ILOC shortens the payment and collection cycle, as payments are effectively made upon presentation of all required paperwork.

Overall, an ILOC is a widely accepted and efficient way for businesses to protect themselves when doing business internationally. By providing a guarantee of payment from the buyer’s bank to the seller’s bank, businesses can rest assured that they will receive payment in the event of default. Additionally, ILOCs offer other advantages such as cost savings, speed, convenience and flexibility. Therefore, it is a highly recommended risk management tool when doing international business.