For new business as well as businesses that are entering international trade, it’s important to manage risks while leveraging new opportunities for growth. Using a financial instrument like a Letter of Credit (LC) can help reduce these risks by acting as a safety net during trade agreements. This article covers how LC works and why it is an essential tool for businesses involved in international trade.
Why New Businesses Face Higher Risk in Cross-Border Trade
Cross border trade requires businesses to have established infrastructure and complex international trade dynamics. They are vulnerable to risks such as:
- Regulatory and compliance challenges
- Financial Vulnerabilities
- Operational and Logistics Hurdles
- Cultural and Market Risks
Against all these risks new businesses have limited risk mitigation which can lead to cash-flow issues, decline in customer attrition and more.
Using a Letter of Credit (LC) to Reduce Risk in Cross-Border Trade
A Letter of Credit (LC) is a payment guarantee from the buyer’s bank, assuring the seller of payment if agreed terms and documents are met. It is widely used in global trade to reduce risk between unfamiliar parties.
How a Letter of Credit Works
- Agreement between Buyer and Seller: Terms of the trade between a buyer and seller are drawn up in the form of a contract and LC is selected as payment method.
- Buyer Requests LC from Their Bank: An application is submitted by the importer to their bank to issue an LC in favour of the exporter (seller). The bank reviews the credit worthiness of the buyer before proceeding.
- Issuance of the LC: The issuing bank provides the LC and sends it to the seller’s bank, normally in the seller’s country.
- Shipment of Goods and Document Submission: The seller dispatches the goods as per the agreement and provides the necessary documents—such as the invoice and transport papers—to their bank for verification.
- Bank Verification and Payment Release: The advising bank verifies the documents. On verification that all is in accordance with the LC details, the issuing bank disburses the amount to the seller.
Key Benefits of Using a Letter of Credit for First-Time Traders (150–170 words)
- Secure Transactions for Both Parties
An LC ensures that exporters receive payment, and importers get their goods as agreed, reducing the risk of fraud or defaults.
- Financial Credibility & Business Expansion
Having an LC-backed transaction enhances a business’s credibility, allowing it to establish stronger relationships with global partners and expand trade operations.
- Cash Flow Optimisation Through LC Discounting
Exporters often need immediate access to working capital before the payment due date. By discounting a Letter of Credit, businesses can sell the LC to a bank or financial institution at a discounted value to obtain instant funds, improving liquidity.
- Compliance with International Trade Standards
LCs ensure that trade transactions follow globally accepted banking and regulatory guidelines, offering additional protection to both buyers and sellers.
Types of Letters of Credit
Different types of Letters of Credit serve specific purposes:
- Commercial LC – It facilitates direct trade payments, ensuring that sellers receive funds once they meet all contract conditions.
- Standby LC – This functions as a backup LC. It ensures that the seller gets paid if the buyer defaults or fails to meet obligations. It is often used as a security measure in long-term trade agreements.
- Revocable LC – This type of letter of credit can be altered or cancelled by the issuing bank or buyer at any time, without needing the seller’s consent. While flexible for buyers, it provides little security for sellers, making it less commonly used in global trade.
- Irrevocable LC – This LC cannot be modified or cancelled without mutual consent from all involved parties. It offers greater security and reliability, making it the preferred choice for international trade agreements.
Businesses often use an export packing credit to maintain cash flow. By receiving early payment from banks against the Letter of Credit, they can reinvest in operations. Managing multiple transactions through a business bank account also streamlines the financial process.
Conclusion
A Letter of Credit helps make international trade more secure by lowering the risk of payment delays or defaults. Having knowledge of how it works, its forms, and how it operates helps business firms to make transactions with less difficulty. With good financial planning, business firms can maximize cash flow, minimize risks, and thrive in foreign markets. LC discounting provides liquidity through early payment for sellers. A business bank account is a financial security and transparency while ensuring seamless access to business financial services required for SME and other types of businesses.
