A letter of credit is a payment tool governed by international standards.
Letter of credit is a payment tool that is governed according to international standards. This instrument allows a person to instruct a bank to make a payment to a third party, as long as certain conditions are met.
The ordering party is the one who purchases the merchandise and instructs the bank to make the payment according to certain clauses. The banking entity, for its part, will assume the obligations only after receiving certain documentation , such as the purchase invoice , customs certificates, etc.
It should be noted that the payer is, in any case, the one who will make the payment at the end of the process. The recipient of this payment, for its part, will be the seller of the merchandise.
Development of the operation
In this way, we find the fact that the action that generates a letter of credit supposes that four clearly delimited subjects intervene in said process. Thus, there is the ordering party or importer who is the one who purchases the merchandise in question and orders the issuing bank to pay based on a series of conditions that are established; the issuing bank, which is the one that opens the documentary credit and makes the aforementioned and corresponding payment based on the aforementioned clauses; the correspondent bank, which is the one that must deliver the money in question to the beneficiary; and finally the beneficiary or exporter who is the one who sells the goods and who ultimately receives the payment.
Specialists affirm that, thanks to its characteristics, the letter of credit is the safest mechanism in international trade , by minimizing the risk in collection. There are two banks involved (one in the country of the importer and issuer of the letter, another in the nation of the exporter who will receive the payment) and the payment only materializes when the buyer receives what was agreed upon.
It is important to note that, when the importer does not pay, the bank in the importer's country maintains the payment obligation once the transaction is due.
Letters of credit are usually irrevocable and nominative.
Characteristics of the letter of credit
Letters of credit can have different characteristics. They are generally irrevocable , that is, the agreement established between the parties cannot be modified without the consent of all those involved. The letters are also usually nominative , since they express which banks are authorized to participate in the operation.
In addition to these two types of letters of credit we have to emphasize that there are also others such as commercial ones. These specifically are those that are opened when the action carried out is a purchase and sale option, either locally or internationally.
Likewise, we cannot ignore the existence of so-called private letters of credit, which in turn are divided into four clearly differentiated groups. Thus, there are first the transferable ones, then the rotating ones, the advance ones and finally those known as “back to back”. The latter, specifically, are those that are implemented by the bank based on a larger credit than the payer himself is the beneficiary.