Letter of Credit is the backbone of all cross border trades. With globalization, the product manufactured or any commodity produced anywhere can be sold in another part of the world. However, how do these transactions take place when the parties to the transaction are not known to each other and their credit histories unverified? The answer to these questions is a letter of credit. It is the document issuing or verifying by a bank of international repute. It contains all the details of the transaction. Details include what is the quantity/ quality of the goods purchased. It also includes how and when the buyer pays.
How Letter of Credit Works
Let’s us assume a local manufacturing company in Africa requires a cutting edge German fabrication machine. This help in improving efficiency and lowering costs. The buyer has come across a seller in Germany who is selling the machine on acceptable terms. However, the buyer is demanding advance payment. The problem is that being a small businessman the buyer does not have resources to fight the case in international court for breach of contract in case the buyer defaults. Besides, if it was a possibility, no business wants to spend it’s resources dealing with avoidable legal issues. Concerns of the sellers include having no recourse in the event of the buyer defaulting payment.
In such situations, it stops the wheels of international trade. The UCP 600 ( Uniform Customs and Practices for Documentary Credits) enables a seamless flow of trade, by governing Letters of Credit. The UCP 600 is publishing by ICC ( International Chamber of Commerce). These rules are in the nature of guidelines that determine international trade.
For instance, in the example above the buyer in Africa would approach it’s banker requesting for issue of a Letter of Credit in favour of the supplier. The terms of the LC clearly mentions the supply of the quality and quantity of goods. This LC gets send to the supplier for shipment of goods. The seller then ships the goods and receives payment according to the terms of Letter of Credit. Both the buyer and seller are thus able to do transactions in this situation by the issuance of a Letter of Credit.