What is the Importance of Letter of Credit in Trade Finance?

International trade finance is a lucrative deal that invites several risky parameters. If one is not careful enough, this trade might turn out to be disastrously dangerous for the organization. The deal is risky for both an importer and an exporter of the goods. However, it is usually more dangerous for the exporter as the importer does not release funds before receiving the right amount of goods. In such cases, the exporter needs some kind of guarantee to claim the necessary payment upon shipping of the goods. This is where the documentary letter of credit helps.

What is Documentary Letter of Credit?

In simple words, the documentary letter of credit is a legal document that binds the importer of goods to send timely payment for the shipment on receiving the goods. In case of failure to pay on time, the importer must pay huge legal fines. The letter of credit is usually issued by one bank to the other. One bank represents the interests of the importer while the other one represents that of the exporter.

Why Involve Banks?

Involving reliable banking institutions in the deal is beneficial for both the importer and the exporter in the deal. For example, if the exporter does not receive the payment for the goods on time, it is not economically feasible for it to chase the importer halfway across the globe. On the other hand, if the importer does not receive the right goods for the payment, it is nearly impossible for it to chase the exporter across the globe. A multinational bank steps into the picture in such scenarios.

The bank will have the necessary resources and connections in the foreign country to contact the exporter/importer for the right goods/money. The bank will most likely act in an impartial manner to make sure that both the parties are happy with the proposed deal.

Importance of Letter of Credit

The exporter and importer, that is the participants of the trade finance deal can choose to have a common bank represent them both or have two different banks in the deal. It is usually a better practice to have a common bank represent both their interests. Under such scenarios, one national branch of the bank will issue a letter of credit for the other national branch of the same bank.

For example, if the exporter belongs to Germany and the importer is from the USA, the German branch of the bank will issue a letter of credit for the US branch of the same bank. It is much more feasible for the bank to collate its effort within the organization than to communicate with a completely separate bank.

The letter of credit will bind the importer to offer the timely payment for the goods in the right amount. In case of international trade finance, the letter of credit is slightly modified into a more secure version, often known as the irrevocable letter of credit.

Bank Guarantee

The exporter of goods may demand a bank guarantee while offering the letter of credit. The bank guarantee suggests that the bank of the importer will take up the responsibility of transferring the right amount back to the exporter in case the importer defaults. This acts like a secondary and more secure way of the transaction for the exporter of goods.

The bank guarantee and letter of credit are two small nuances of international trade finance. When you look at the bigger picture, a lot more technicalities are involved in a multi-million-dollar deal.

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