The letter of credit has been a useful tool in trade, from ancient society to modern day. As long as a buyer has a letter of credit, a company can feel safe in supplying or manufacturing goods for a shipment because they know they are going to get paid.
A letter of credit is a letter written by a bank or financial institution that ensures a seller (beneficiary) that the buyer’s (applicant) money is as good as he says it is. Basically, it’s a guarantee that the buyer’s bank will cover the payment in full and on time. If for some reason the buyer cannot make the payment to the seller, the bank will do so. In almost all cases in international trade, the beneficiary is the exporter and the applicant is the importer. Payment can go either to the seller’s bank or directly to the seller.
The letter of credit has become a popular way to guarantee payment in international dealings because of the complexity of international trade. The letter of credit makes it much easier to do business across time zones and in countries with differing laws. To issue a letter of credit banks will need important trading documents such as the BoL, invoices, copies of insurance policies, and mandatory permits (like inspection and phytosanitary certificates) issued by the government where the business is conducted.
Some historians believe the letter of credit dates back to the renaissance, and other scholars point further back to ancient Greece or Rome. In fact, examples of prototype letters of credit have been found proving their importance throughout ancient history. Considering that letters of credit are very much a part of today’s world, that’s a long time for something to remain relevant.
A 3000 year old Babylonian artifact, a clay note that promised repayment to the holder, proves that letters of credit played a role in ancient Babylonian banking. It is also known that the banks of ancient Greece wrote similar notes, promising payment at a specific date in wheat, goods, or whatever currency the beneficiary expected. As international trading, along with society’s growth, slowed with the dark ages and fall of the Roman Empire, we don’t see letters of credit popping up again until the renaissance. With traveling and trading perking up after major cities were finally thriving, it was much safer and far easier to carry a letter of credit than to carry chests of gold.
The Medici banking dynasty, the most well-known example of renaissance patrons, issued letters of credit that are quite similar to the ones used today. Renaissance letters of credit had many of the same requirements of modern ones, such as payments could only be requested by the person named as beneficiary, and they could only be for a certain amount. Likewise, the renaissance version required the use of receipts and ensured that the payment would be charged to the account of buyer. As the centuries rolled on letters of credit transformed, acting somewhat akin to a traveler’s check.
By the 1800s, British banks were the most powerful on the globe and issued most of the trade world’s letters of credit. But soon the United States financial star was also rising, and along with it, the use of letters of credit by US merchants who had to navigate the newly broken trading world, thanks to WWII. With trade networks and much of Europe in shambles, a space was created for trusted US institutions to guarantee payment two parties involved in both domestic and international trade. Decades later, US still relies heavily on letters of credit to facilitate payment in the always-changing world of international trade.
There are several types of letters of credit.
Revocable – this type (which has fallen out of favor) allows the letter of credit to be changed by the issuer or the buyer, without any notice given to the beneficiary.
Irrevocable – the issuer can change or cancel this letter of credit at the behest of the buyer, but only with official approval from the beneficiary.
Confirmed – this is like a ‘back up’ letter of credit requested by the bank that issues the first letter of credit. The second bank agrees to make the payment if the first bank cannot. Confirmed letters of credit are usually asked for when the initial issuing bank is not trusted.
Transferable – if the beneficiary is representing the company that actually supplied the goods being purchased, they will use a transferable letter of credit in order to ensure that company receives payment. This letter of credit allows the beneficiary to transfer some or all of the payment.
At Sight – this letter of credit can be paid as soon as it is presented and verified.
Deferred – this letter of credit allows for the passing of a certain amount of time, likely in the case that the buyer needs to sell the received goods in order to pay the beneficiary.
Red Clause – originally written in red ink, this letter of credit allows for a partial payment to be made before the goods have been shipped by the beneficiary. These are rarely used, unless the beneficiary is very trustworthy or a second bank has agreed to make repayment if the goods do not get shipped.
Back-To-Back – if a third party is involved, such as a trading house, this type of letter of credit will be used. It consists of two letters of credit, one from buyer’s bank to the third party and one from the third party’s bank to the seller of the goods.
There are a lot of different types of letters of credit because there are many different situations that arise in the ever changing world of global trade. Selling goods means using the correct letter of credit for your shipment in order to guarantee payment.