Letter of Credit

Letter of Credit

This kind of facility falls under non-fund based & is a kind of letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
And due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
In this bank also acts on behalf of the buyer (holder of the letter of credit) by ensuring that the supplier will not be paid until the bank receives a confirmation that the goods have been shipped. Further, letter of credit is a cost-effective source of finance for working capital as the bank only charges commission as against interest in case of Cash Credit or Overdraft facility.


  • Pre-shipment Credit in Foreign Currency must be extended to Standard Accounts.
  • Letters of credit are often used within the international trade industry.
  • There are many different letters of credit including one called a revolving letter of credit.
  • Banks collect a fee for issuing a letter of credit.

What is it used for?

If you are an importer, using a letter of credit can ensure that your company only pays for goods after the supplier has provided evidence that they have been shipped. It also allows you to conserve your cash flow, since you don’t have to make any advance payments or deposits to the exporter. Finally, the letter of credit gives you instant credibility with an exporter by demonstrating your creditworthiness.
If you are an exporter, the letter of credit is insurance in case the buyer fails to pay for the goods you shipped. In such a case, the financial institution will cover the amount outstanding. The letter of credit also protects you against legal risks since you are ensured payment as long as delivery conditions have been met.
For exporters, a letter of credit can also be pledged as collateral against working capital loans to help you fill your order.

Who is involved?

Normally, the bank’s customer is the importer, or the buyer of the goods. They work with the bank to issue the letter of credit to the beneficiary.
The beneficiary is the exporter, otherwise known as the seller or supplier of the goods.

How does it work?

The letter of credit outlines the conditions under which payment will be made to an exporter.
The issuing bank will generally act on behalf of its client (the buyer) to ensure that all conditions have been met before the funds of the letter of credit are released.
What is a discount rate?
A letter of credit may have a discount rate. That means that the buyer may not have been the one to close the deal with the seller. Perhaps it was arranged by a broker or the buyer’s agent. In that case, the difference between the actual amount available for purchase and the full value of the letter of credit is the commission earned by the broker.

What is a back-to-back letter of credit?

Back-to-back letters of credit are typically used when a seller has to purchase a component or subcontract part of the manufacturing of a product to a third party, but does not have the cash flow to do so.
In this case, the buyer obtains a letter of credit for the beneficiary (the seller). Once the letter of credit has been received by the seller’s bank, the seller can apply with his bank for a second letter of credit of a lesser value. This second letter of credit is sent to the third-party supplier’s bank so that the supplier knows that he or she will be paid and can proceed with that part of the transaction.
Back-to-back letters of credit can also be used to guarantee commission payments to a party acting as an agent for the seller.
What is a letter of guarantee?
If you are a seller dealing with customers outside of Canada, they may require you to provide guarantees before doing business with you.

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