A letter of credit is an important and widely-utilized financial instrument in international trade. It is a document issued by a bank or another financial institution, guaranteeing payment for goods or services delivered by a seller. The document guarantees that a buyer’s payment to a seller is made on time and in full, allowing businesses from all over the world to exchange goods without having to worry about possible defaults or payment-related risks.

When a letter of credit is issued, the buyer’s bank (the “issuing bank”) opens a credit line for the seller and holds the funds in escrow until the transaction is completed. The issuing bank reviews the documents submitted by the seller and will only release funds to the seller if the documents comply with the conditions of the letter of credit. This means that the buyer is protected from any financial losses due to non-delivery or under-delivery.

The two most common types of letters of credit are revocable and irrevocable letters of credit. An irrevocable letter of credit is one that cannot be altered or cancelled without mutual consent of the buyer and the issuing bank. A revocable letter of credit can be amended or cancelled by the issuing bank without the consent of the buyer.

The process of issuing a letter of credit requires both the buyer and the seller to adhere to a prescribed set of instructions known as the UCP (Uniform Customs and Practice for Documentary Credits). This is an international standard aimed at ensuring uniformity in the process of issuing letters of credit. The UCP is managed and administered by an organization called International Chamber of Commerce (ICC).

Banks collect a fee for issuing a letter of credit, known as the processing fee. Other fees may apply based on the buyer’s and the issuing bank’s criteria. In addition, the buyer’s bank may also ask a deposit or a security deposit to be placed with the issuing bank so that the letter of credit can be issued.

Overall, a letter of credit is an essential instrument that allows buyers and sellers to safely exchange goods and services in the international market. Not only does it provide protection to both parties in a transaction, but it also ensures that funds are transferred in a timely manner and that payment obligations are met.