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A letter of credit is a document from a financial institution such as a bank that guarantees payment for satisfying the terms of a business deal. An irrevocable letter of credit cannot be rescinded and, thus, is a way to reduce the risk of conducting business. Common in international trade, irrevocable letters are used as a secure form of payment across borders and typically involve two businesses and two banks. Both the buyer and seller are guaranteed they will receive the promised work or product from the other party, because the intermediary banks will not pay if the businesses do not perform the agreed upon actions.
An irrevocable letter of credit is only one type of letter of credit. A letter of credit can come with various levels of protection. For instance, a transferable letter of credit is when the seller can assign part or all of his right to receive funds to another party.
When using a letter of credit, two businesses — a buyer and a seller — will agree to payment by letter of credit via two intermediary banks — an issuing bank and an accepting bank. The buyer will request the issuing bank to create a letter of credit to authorize payment if the seller fulfills specific requirements. After the seller completes the specific actions, he must provide proof, such as shipping receipts, to the accepting bank. The accepting bank will verify the documents, request and receive funds from the issuing bank, and pay the seller.
Although a letter of credit can be revocable, more commonly they are not. If the seller, buyer and issuing bank agree, an irrevocable letter of credit can be modified. Otherwise, the buyer is legally bound to pay the seller. In the event the buyer does not pay, the issuing bank is required to pay the seller and can seek reimbursement from the buyer.
An irrevocable letter of credit is most often used in trade finance, the financing of international trade, however, it is also admissible in national trade. The structure of the transaction provides extra security to the buyer and seller because it uses banks as intermediaries. Both transacting parties are assured they will receive the agreed upon goods and payment. A letter of credit is honored across borders, languages, and legal differences.
A common mistake is to assume that a letter of credit and a line of credit are the same thing. A line of credit is similar to a pre-approved loan or credit card between a business and a bank. The business can draw on the line of credit at will. Both terms are abbreviated as LOC, but the acronym most often refers to a line of credit.