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Letter of credit business: definition & important aspects for buyers
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Letter of credit business in a nutshell:
A letter of credit is an irrevocable promise of payment by a bank, whereby the bank undertakes to pay the agreed purchase price to the seller on presentation of certain documents. For the buyer, it offers maximum payment security for international transactions and minimizes risks, as payment is only made once the correct documents have been presented.
Example: A German company imports machinery worth EUR 250,000 from China and opens a letter of credit via its house bank that guarantees payment to the Chinese supplier within 30 days of presentation of the agreed shipping documents.
Contents
Introduction to the letter of credit business
What is a letter of credit transaction?
A letter of credit is an internationally recognized instrument for securing payments and deliveries in foreign trade. The importer's bank (issuing bank) promises to make a payment to the exporter (beneficiary) as soon as the exporter presents the documents specified in the letter of credit. This procedure minimizes risks such as non-payment or non-delivery and creates trust between business partners who may not know each other personally.
Core elements of the letter of credit business
Significance for purchasing
In the procurement process of international companies, the letter of credit business plays a decisive role in securing supply chains and payment flows. It enables buyers to source goods from unknown or new suppliers without taking the full risk of prepayment. By involving banks, trust is strengthened, which facilitates market entry into new countries and supports the global procurement strategy.
Application of the letter of credit transaction in practice
The letter of credit transaction is used to secure international payments by involving a bank as a guarantor. The buyer initiates a letter of credit in favor of the seller, which guarantees payment as soon as the agreed documents are presented.
Practical example
Situation: A German company orders electronic components worth 50,000 euros from a new supplier in Taiwan:
- Opening of the letter of credit: The German buyer instructs his bank to open an irrevocable documentary letter of credit in favor of the Taiwanese seller.
- Specification of documents: The conditions agreed are the submission of a commercial invoice, packing list and a shipping document (bill of lading).
- Shipping the goods: The seller ships the components and receives the necessary documents from the shipping company.
- Document submission: The seller submits the documents to his bank, which forwards them to the buyer's bank.
- Verification and payment: The buyer's bank checks the documents for compliance with the terms and conditions of the letter of credit. If the result is positive, payment is made to the seller.
Benefit: Both parties minimize their risk: the buyer only pays upon proof of shipment, the seller receives a payment commitment from a reputable bank.
Evaluation and strategic insights into the letter of credit business
✓ Critical success factors
→ Precise documentation: Precise definition of all required documents and conditions in the letter of credit to avoid delays
→ Banking expertise: Selection of an experienced bank with an international network and expertise in the letter of credit business
→ Process management: structured internal processes for fast document review and forwarding
⚠ Challenges and limitations
→ Cost aspect: Higher transaction costs due to bank fees and administrative expenses
→ Time factor: Longer throughput times due to formal inspection processes and document processing
→ Complexity: High training requirements for employees due to complex legal and formal requirements
Future trends and developments:
"Digitalization is revolutionizing the traditional letter of credit business through blockchain and smart contracts."
→ Digital letters of credit with reduced paperwork
→ Blockchain-based document verification
→ Integration of AI for automated compliance checks
→ Real-time tracking of the letter of credit status
◆ Strategic implications
→ Risk management: Systematic evaluation of when letters of credit make sense as a hedging instrument
→ Digitalization: Investment in digital platforms for efficient processing of letters of credit
→ Supplier relationships: Using letters of credit as a confidence-building measure for new international partnerships
Conclusion on the letter of credit business
The letter of credit business is an indispensable instrument in international trade that offers decisive advantages despite higher costs and administrative effort. It minimizes risks for all parties involved, creates trust between unknown trading partners and enables secure global business relationships. With increasing digitalization, the letter of credit business is becoming more efficient and user-friendly, but its basic function as a hedging instrument remains important for international trade.
