What is a letter of credit?

A letter of credit, also called "commercial credit"Or"letter of credit”Is an instrument issued by a banking institution or any other financial institution, in order to ensure that a buyer's payment to a seller is made on time and in the full amount agreed upon in the negotiation.

The letter of credit is a payment method that obliges the issuing entity to cover the full amount of the agreed amount or the remainder of it in case the buyer is unable to cancel the total amount of the purchase.

Due to the nature of international deals that include factors such as distance, the laws that govern and that are different in each country and the difficulty of personally contacting the participating parties, makes the use of letters of credit very important in the management of the market or trade international.

In other words, a letter of credit has as its main function guarantee distance buying and selling within a country and also export to other countries. It is an instrument through which an issuing institute, on the instructions of a buyer or importer, makes a payment to a third party or beneficiary, seller or exporter, after compliance with the documentation required.

Types of letters of credit

Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any financial institution nominated by the beneficiary. Banks usually require a series of commitments or guarantees or cash to issue the letter and also charge a fee for the service.

The types of letters of credit Common ones are mentioned below:

• Commercial: it is a direct method of payment in which the issuing bank pays the beneficiary only when the holder or holder does not. That is, it is applied for a purchase-sale operation at a local or international level.
• Confirmed: is one where a second bank agrees to pay the letter of credit when the issuing bank requires it. The confirming bank guarantees the payment of the letter of credit if the holder or the issuing bank fails. Usually, the issuing bank requires this type of arrangement. This second bank is generally the seller's bank.
• Renewable: this type of letter allows the client to renew, within certain limits, the use of the letter of credit. The amount remains constant for a specified period of time so that when it is used, it is The entire amount is available again, either automatically or as soon as the issuer agrees with the documents.
• Irrevocable: This instrument represents a firm commitment to pay the beneficiary with its resources, once it has been verified that all the terms and conditions of the credit have been met. It would only allow changes if the issuer, buyer and beneficiary agree.
• Revocable: can be changed or amended at any time by the buyer or issuing bank without notifying the beneficiary.

Characteristics of letters of credit.

The credit letters They are issued by banks or any other financial institution and generally have three participants: the beneficiary, who is the person or company that will pay; the buyer who is the one who needs the letter of credit and the bank or institution issuing said letter.

Between the characteristics of letters of credit the following may be mentioned:

• It is a widely used medium in the international buying and selling trade.
• Provides the seller with high payment security.
• They are usually negotiable.
• They include an unconditional commitment to pay and in a specified time.
• It has a commercial code as this instrument does not present doubts about the correctness of the issuing bank's negotiation and its payment obligation.
• They can be revocable or irrevocable. This condition must appear clearly on the title page of the document to know the type of credit that is being presented.
• The letter of credit can be revoked at any time by the issuing bank without notice. as long as it is done before the document has met all the conditions and has been presented.
• A revocable letter cannot be confirmed.

Why are letters of credit important?

Today, letters of credit are one of the most reliable means in international trade. They are indispensable instruments in transactions and commercial management because with them it is ensured that the payment will be made on time and correctly.

They are also governed by the UCP (Central Processing Unit) which are international rules that regulate the origination, collection and termination of documentary credits or letters of credit. These instruments consist of a payment agreement upon presentation of some pre-established documents that support it.