Mostly issued by financial institutions, a letter of credit (LC) is a standard document which is primarily used in the trade finances to provide irrevocable payment undertakings. In simple terms, it is a letter from a bank that guarantees that the payment from a buyer to the seller will be for the correct amount and on time. If for any reason, the buyer defaults on the payment, the bank that issued the letter of credit will have to pay the full or remaining amount to the seller.

The are various factors that affect international trade such as the distance between the two parties, differences in the laws of the countries of involved parties and most importantly the possible hurdles of knowing each other personally. Hence, to ensure that the payment will be received, letter of credit is mostly used in international transactions.

Due to this, the letter of credit is used extensively and has become an important aspect and integral part of international trade. Also, the bank acts on behalf of the holder of LC i.e. the buyer and ensures that the payment to the seller is not made until it receives a confirmation of the shipping of the goods.

Letters of credit deal in the documents, not the goods and are chiefly of two types, revocable and irrevocable. The irrevocable ones cannot be changed unless both, the buyer and the seller consent to it whereas a revocable LC can be changed without the beneficiary’s consent. Another type known as slight LC is where, upon the presentation and receipt of necessary documents, the payment is immediately made.

According to the terms and conditions, it is the applicant of the letter of credit that bears all the charges of issuance along with other charges such as the courier, reimbursement and negotiation of documents. Also, the letters of credit are not devoid of risks; there are various situations like fraud and legal risks that can affect both the buyer and the bank.