Letter of credit (LC)
A letter of credit (LC) is a bank's commitment to pay a seller a stated amount once the seller presents documents, typically the bill of lading, commercial invoice, and packing list, that exactly match the conditions written in the credit. By substituting the bank's creditworthiness for the buyer's, an LC makes trade possible between parties with no payment history or in higher-risk markets.
Examples
First-order protection: A robotics startup orders $380,000 of precision gearboxes from an overseas supplier it has never used. The supplier will not ship on open account and the startup will not prepay, so the startup's bank issues an irrevocable sight LC for about $3,800 in fees and the order ships two weeks later.
Discrepancy cost: A presentation names the consignee as Acme Mfg Inc while the credit reads Acme Manufacturing Inc. The bank flags the discrepancy and $1.2 million waits nine days for the buyer's waiver. The seller's fix is mechanical: copy every name and address character for character from the credit.
Definition
Issuance starts on the buyer's side: the buyer's bank opens the credit in the seller's favor, spelling out the documents required and the deadline to present them. The seller ships, assembles the paperwork, usually a bill of lading, commercial invoice, packing list, and sometimes inspection or insurance certificates, and presents it through its own bank.
Banks deal in documents, not goods. A conforming presentation gets paid even if the buyer dislikes the shipment; a non-conforming one stalls regardless of the condition of the goods. Most credits run under the ICC's UCP 600 rules.
LCs earn their fees in specific situations: a first order from an unfamiliar buyer, a single large equipment sale, a market with currency controls. A confirmed LC adds a second bank's undertaking when the seller does not trust the issuing bank's country risk. The documents must also line up with the agreed Incoterms rule; a CIF shipment, for instance, needs an insurance certificate in the presentation.
The operational trap is discrepancies: a consignee name spelled differently than in the credit or a presentation one day late can stall payment until the buyer waives the defect. As relationships mature, most trading pairs retire LCs in favor of open account payment terms, sometimes with supply chain finance taking over the financing role.
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