The Letter of Credit is critically important in international trade due to the following reasons:
1. Risk Mitigation: It mitigates risks for both buyers and sellers. Sellers are assured of payment even if the buyer defaults, and buyers may receive some protection against the non-delivery of goods.
2. Enhanced Trust: An LC provides trust in transactions where buyers and sellers may not know each other and are operating under different legal systems.
3. Payment Security: It guarantees that the seller will receive payment on time as long as the terms and conditions stated in the LC are met.
4. Creditworthiness: It substitutes the bank’s creditworthiness for that of the buyer, which is especially useful when the seller is unsure of the buyer’s financial stability.
5. Customizable Terms: The terms of an LC can be precisely tailored to the needs of both buyer and seller, detailing the exact requirements for the transaction.
6. Facilitates Trade Finance: An LC is often used as a base for other trade finance methods like discounting, negotiation, and acceptance.
1. International Trade: Primarily used in international transactions to ensure payment when reliable credit information about the foreign buyer might be difficult to obtain.
2. Large Transactions: Often used for large purchases where the seller may be required to make substantial investments in production capacity.
3. Construction and Capital Goods: Used in the construction industry and in the sale of capital goods where delivery and payment may be spread over a longer period of time.
4. Regulatory Compliance: Assists in fulfilling export/import control requirements, ensuring transactions comply with international trade laws.
Revocable LC: Can be altered or canceled by the issuing bank without beneficiary consent (rarely used).
Irrevocable LC: Cannot be changed unless all parties agree, offering greater security.
Confirmed LC: Adds another bank’s guarantee, typically the seller’s bank, on top of the issuing bank’s commitment.
Unconfirmed LC: The guarantee is only provided by the issuing bank.
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