What is the purpose of a letter of credit?

A letter of credit serves as a financial instrument that provides a guarantee of payment from a bank to a seller on behalf of a buyer, provided that the seller meets the specific terms set out in the letter. This is particularly important in international trade, where the seller requires assurance that they will receive payment before shipping goods.

In practice, when a buyer applies for a letter of credit, the bank assesses the buyer's creditworthiness and issues the letter, which specifies the payment amount, conditions, and an expiration date. Once the seller delivers the goods and presents the required documents, such as shipping and insurance certificates, to the bank, the bank is obligated to make the payment to the seller.

This arrangement reduces the seller's risk significantly as they have the bank's promise of payment, making them more likely to engage in transactions with buyers who may be located in different geographical locations or who are new to them. By ensuring that the seller will be paid, letters of credit facilitate smoother business transactions and build trust between trading partners.