If you’re doing business internationally, you may have come across a requirement for a commercial letter of credit. This financial document serves as a guarantee of payment for goods or services, thereby playing an important role in facilitating international trade and industry growth.
These letters can help businesses work successfully with new clients and can build trust. Learn more about how they work and their pros and cons here.
What Is a Commercial Letter of Credit?
A commercial letter of credit, also known as a documentary credit, is an aspect of business banking. It’s a document issued by a bank to guarantee payment for goods or services for a seller (also called the supplier or exporter). It is issued on behalf of the company acquiring the supplies (the importer). It ensures that suppliers are paid for the services and/or goods they provide and that buyers receive the goods or services promised. This can be an important tool when doing business internationally or working with a new supplier. Simply put, it supports the deal and inspires trust.
Most of us know that good credit is important, and with a bank’s assistance, a commercial letter of credit can vouch for a new and/or foreign business partner. Let’s say an American company has never done business with Thailand before but wants to. Or it’s found some goods it would like to buy from a company in France, but that business only started a few months ago. There can be an element of risk to this kind of deal. The commercial letter of credit can reduce that worry since a bank steps in as a third party.
Commercial letters of credit are considered to be a very secure form of payment and are able to power many international trade transactions. The parties involved typically have every reason to believe the deal is solid, thanks to the bank’s participation.
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How Does a Commercial Letter of Credit Work?
A commercial letter of credit is more than a piece of paper promising payment. It acts a bit like an escrow agent between buyer and seller.
To explain it in more detail, a business (the buyer) can obtain a commercial letter of credit by applying for one at a bank or commercial lending institution. The seller may require this when the relationship is new (or perhaps the buyer is new and their credit history is not yet solid) or when exporting to another country.
After approval, the bank issues a letter of credit for the supplier (also called the beneficiary). This letter signals to the seller that the funds are guaranteed and will be paid by the bank, making it safe for the seller to produce goods or provide services for the buyer.
Once the seller shows evidence of having provided services or shipped the goods to the buyer (such as a bill of lading), the seller can draw on the letter of credit using their own bank. After payment has been made to the seller, the buyer must reimburse the bank before receiving the documents necessary to take delivery of the goods from the supplier.
By using a bank in this way, both the buyer and seller can feel confident in the business transaction.
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Protections Offered by a Commercial Letter of Credit
A commercial letter of credit offers protections for both the buyer and seller. This is one of the reasons why it’s such an important tool.
• For the seller (or supplier), the letter guarantees payment for goods or services.
• For the buyer, the letter requires sellers to provide these goods or services before payment is issued.
These are particularly important in international trade where market conditions vary around the world and trust comes at a premium. For instance, a location might have intense climate conditions that threaten production or perhaps there’s political instability at a given moment. With a commercial letter of credit, participants in a deal can feel more secure about the deal going smoothly and successfully.
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What Parties Are Involved in a Commercial Letter of Credit?
There are always four parties involved with executing a commercial letter of credit. These are:
• Buyer: The party who applies for a letter of credit from their bank.
• Supplier: The seller of goods or services the buyer desires.
• Issuing bank: The bank of the buyer who has approved a letter of credit.
• Supplier’s bank: The financial institution from which the supplier can draw on the letter of credit. The supplier will then receive payment via the issuing bank.
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Commercial Letter of Credit Process Example
Here’s an imaginary example of how a commercial letter of credit might be used during an international business deal: The Winter Company makes blankets in the U.S. and needs to order raw material from China. They want to order from a new supplier, Fine Fibers, and that new supplier wants to be sure this is a legitimate, reliable deal before beginning work. Therefore, Fine Fibers asks for a commercial letter of credit in order to start manufacturing the material for the blankets.
The Winter Company (the buyer/importer) applies for a commercial letter of credit from their bank and is approved. The letter is sent to the seller/supplier/exporter, Fine Fibers. It then begins manufacturing the material needed by the blanket-making company.
After finishing the order, Fine Fibers ships the order and provides the bank with the bill of lading. The fiber company can collect payment from the bank using their own bank.
The Winter Company, the buyer, can pay their bank back, and the bank will release information to receive the shipment. The buyer now has possession of the goods shipped. The deal is done without any hitches.
Difference Between a Commercial Letter of Credit & a Standby Letter of Credit?
There are many different types of letters of credit. One of the other commonly used letters of credit is a standby letter of credit. There are a few differences between a commercial letter of credit and a standby letter of credit, which are explored here.
| Commercial Letter of Credit | Standby Letter of Credit |
|---|---|
| Bank pays the beneficiary | Bank pays the beneficiary only if the buyer cannot |
| Acts as payment | Acts more like a default or back-up payment method |
| Buyer must apply and be approved for a commercial letter of credit | Buyer goes through underwriting to examine their creditworthiness |
| Used as the primary financing instrument | Used when a deal is threatening to fall through |
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Examples of Commercial Letters of Credit
For both domestic and international transactions, commercial letters of credit can fulfill payment according to the contract’s specifications and help identify the goods’ delivery so a final payment can be made.
For example, Wells Fargo offers these letters to business clients. The letters of credit have a renewable term and typically take two weeks to process once the Letter of Credit application has been completed. Many other banks (Citibank, for instance) also offer these letters of credit too, facilitating business deals.
Pros of a Commercial Letter of Credit
There are benefits for both the seller and the buyer for using a commercial letter of credit.
For the seller/exporter
• Ensures supplier is paid when requirements are met, building trust
• Payment can be remitted to a bank of their choice
• Can access financing in many countries by having a letter of credit
• Helps develop new trade relationships, especially internationally
For the buyer/importer
• Reduces the amount of money tied up in a lengthy transaction
• Allows the buyer to stipulate terms and conditions for fulfillment of the contract before payment is made by the issuing bank
• Ensures goods or services are provided to the buyer, building trust
• Helps develop new trade relationships, especially internationally
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Cons of a Commercial Letter of Credit
There are a few drawbacks to consider, however, when using commercial letters of credit. These include:
For the seller/exporter
• Payment takes longer than with an all-cash transaction.
• Compliance with conditions of the contract may delay payment.
For the buyer/importer
• Application process can take two weeks or longer.
• Can be pricey. The bank fee for a letter of credit is usually taken as a percentage of the amount of goods sold.
Recommended: Differences Between a Bank Guarantee and a Letter of Credit
The Takeaway
A commercial letter of credit can help you businesses conduct transactions by guaranteeing payment from the issuing bank once requirements are met. This way, you can work with new businesses to dependably complete deals domestically and internationally. Commercial letters of credit can be a valuable asset in building trade and trust.
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FAQ
Who is the beneficiary in a commercial letter of credit?
A commercial letter of credit facilitates trade by guaranteeing funds (payment) for a supplier. The beneficiary is the receiver of the funds, whether the seller or the bank named by the recipient.
What is a letter of credit in commercial banking?
A letter of credit in commercial banking is a document from a bank guaranteeing payment to a supplier once a deal’s conditions are met. Typically, it is used in international trade and/or between companies that have not done business previously.
Why do you need a letter of credit?
You may need a commercial letter of credit if your company is working with a new supplier that doesn’t offer trade credit, your supplier is outside the country or your normal trading area, or your company doesn’t have enough credit history for a supplier to trust your ability to pay.
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