Definition of a Commercial Letter of Credit
A commercial letter of credit is a document used to substitute the bank’s credit for the customer’s with the aim of facilitating trade. This letter is taken as the primary payment tool for a transaction.
How Does a Commercial Letter of Credit Work?
- A seller and buyer are conducting a business transaction. The seller asks for a letter of credit to be guaranteed of payment.
- The buyer applies to a bank for a commercial letter of credit.
- The buyer’s bank receives, approves and processes the buyer’s credit risk then forwards the document to the correspondent bank, a financial institution that can help facilitate the transaction on behalf of another bank, for further consideration and confirmation.
- The advising bank, which advises a beneficiary that a letter of credit opened by an issuing bank for an applicant is available, then authenticates and forwards the credit to the beneficiary (seller).
- Seller develops the necessary documentation to support the letter of credit and then ships the goods or provides services.
- The beneficiary presents the supporting documents to the receiving or advising bank for payment processing.
- The confirming bank checks if the documents comply with the terms and conditions in the letter of credit.
- If the documents comply, the confirming or advising bank claims the funds by doing any of the following:
- Debiting the account of the issuing bank, or
- Waiting for the issuing bank to remit after receiving the documents or
- Reimbursing another bank as provided for in the letter of credit.
- The advising bank forwards the document to the issuing bank.
- The issuing bank assesses the documents to determine if they comply and if they do, the issuing bank debits the buyer’s account.
- The issuing bank forwards the same documents to the buyer.
How to Get a Commercial Letter of Credit for Your Business
You apply for a letter of credit through the bank. You should, however, know two things before you get started: 1) You must have a good credit history; and 2) You should work with a bank with which you already have an established relationship. A prior relationship with a bank is particularly important for new businesses, which do not have a significant credit history.
The bank will require documentation of the transaction as well as other supporting documents required for internal processing. If the money is already in the company’s account, the bank shall require that the money is remitted upfront. Or, the bank might reserve a margin of that amount to meet buyer obligations. The margin amount will vary depending on the needs of the buyer, the transaction history, how well the company is established, credit score as well other factors. Risky buyers might be required to remit up to 100 percent of the purchase money to get a letter of credit.
The use of commercial letters of credit is preferred because it reduces the associated risks. For this reason, their use has grown substantially over the past few decades.