A letter of credit is a three-party agreement. The parties are the buyer, the financial institution (like a bank), and the seller. In the agreement, the financial institution or bank will guarantee the seller that they will receive money due from the buyer. If the buyer doesn't pay, the financial institution will bear the cost or balance of what is owed.

The letter of credit eliminates many risks and smoothes international trade. It's an essential instrument in international trade because it caters to its biggest risk: the buyer doesn't receive the goods, and the seller doesn't receive payment. Remember that the buyer and seller are usually far apart geographically, are in different jurisdictions, and may not have physically met, among other concerns.

A letter of credit is a service that financial institutions provide, so it comes at a fee. Banks typically charge a small percentage of the guarantee as their fee, typically less than one per cent. The different types of letters of credit are:

• Commercial Letter of Credit, wherein the bank pays directly to the beneficiary.
• Revolving Letter of Credit which enables the customer to draw from it within a total dollar limit and period.
• Traveller's Letter of Credit guarantees withdrawals from certain foreign banks.
• Confirmed Letter of Credit which has a second bank to guarantee payment to the seller.

The different types of letters of credit offer protections and limitations for each type. The letter of credit that will work for you will depend on your circumstances and your relationships with the customer and bank.

How a letter of credit works

When a buyer and seller agree on a sale, they will need a letter of credit. The seller will ask the buyer to get a letter of credit from a financial institution.

The buyer must go through a similar process to applying for a loan. Usually, the buyer will need to hand in the purchase contract, a copy of the purchase order or export contract, and a few other documents the financial institution requires. The financial institution will do its due diligence to ensure it doesn't take on too much risk.

If the financial institution approves the letter of credit, the buyer will have a guarantee for the transaction amount. The guarantee establishes trust between the buyer and seller. Although letters of credit feature prominently in international trade, trading parties can also use them for domestic trade.

How the money moves

The money behind the guarantee can come from an upfront payment by the buyer to the financial institution, frozen funds held at the financial institution, or a line of credit.

The seller must deliver to the agreed-upon location, like a ship, port, or factory. To prove delivery, the seller will need to provide documents to the financial institution, such as bills of lading, commercial invoice, certificate of origin, or analysis reports. The financial institution will only release the funds to the seller upon delivery of the goods.

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Another example is Export Portal's blockchain-based trade portal. Companies can use the platform to interact with each other directly. The blockchain ensures that all transactions such as money transfers, communications, or documentation are stored and transacted safely without involving any third-party actors. Check out the import-export website today!


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