Letter of Credit: Definition and How it Works

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What is a Letter of Credit?

Letter of Credit is a document that guarantees customer payments to business owners. This file is issued by the bank and ensures that the payment has been fulfilled on time. Basically, Letter of Credit is one way to facilitate transactions between exporters and importers of products.


There are several types of Letter of Credit that you need to know:


Acceptance Credit or Time Credit

There are notes that are drawn and paid after the period, also known as futures notes. With Acceptance Credit, futures notes can be received immediately and are valid until the maturity date.


For example, a company buys raw materials from suppliers and receives the goods on the same day. The invoice will be included with the delivery of the materials. However, the company has up to a month to settle the bill. This month period marks the time period of the sale.


Revocable Credit and Irrevocable Credit

A Revocable Credit may be changed or canceled terms and conditions by the bank concerned. This cancellation can be done without prior notification to the customer. Meanwhile, Irrevocable Credit is the opposite. The terms and conditions of this document cannot be canceled, let alone changed. Then, the bank concerned will be bound by the commitment written in the Letter of Credit so that it is not arbitrary.


Sight Credit

This document is used for direct or upfront payments. For example, a business person may issue a note to a lender along with a Sight Credit. Then, business owners can take the funds they need directly. This type of letter of credit is the fastest compared to other types of letters of credit.


Then, there is also a confirmed letter of credit. Confirmed Credit allows bankers other than the issuing bank to add their own confirmation in the Letter of Credit. In this case, the issuing bank customer can submit the documents to the confirming banker. In addition, only Irrevocable Credit can be confirmed. Types of Confirmed Credit include the following:


Transferable Credit

Letter of Credit is not a negotiable instrument. However, related notes can be used in negotiations. Transferable Credit is a document that can be transferred to a third party. This document should explicitly mention Transferable Credit.


Also read: Funding Becomes Safer with Credit Insurance Protection at Akseleran!


Back-to-Back Credit

In this type, the exporter asks his banker to issue a Letter of Credit addressed to the supplier. This is so that exporters get products and raw materials as written in the document.


How does it work?

Letters of Credit generally offer two guarantees, namely:


Seller protection

If the client fails to pay the merchant, the bank that issues the Letter of Credit must pay the seller as long as the business owner fulfills all the requirements in the document. Letter of Credit provides a sense of security for sellers and buyers who come from different countries.


Buyer Protection

Letter of Credit also offers protection to customers. For example, when you pay someone to provide a service or product and they fail to deliver. Letter of Credit functions in returning your money. As a result, the seller will be penalized for not being able to fulfill his responsibilities.


The concept of Letter of Credit is almost the same as the Escrow service, which positions the bank as a third party that is not bound by anyone. Banks will only issue funds after meeting certain situations and conditions. Letters of Credit are not only useful for international trade, but also for domestic transactions such as construction projects.


Letter of Credit is the perfect solution for international transactions. Therefore, for those of you who act as business actors with foreign clients, it is very important to understand the meaning and workings of a Letter of Credit. Then, create smooth and secure transactions to support the progress of your business. Hopefully this information is useful and adds insight!

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