A Letter of credit financing is the most common form of trade finance. It is used when the seller (exporter) is unwilling to provide credit terms to a buyer (importer). It is common practice to refuse credit terms to companies in foreign countries as it can be difficult to chase payments across borders-particularly if that country is not politically stable. To reduce the risk of non-payment, the buyer's bank issues a letter of credit, guaranteeing payment to the seller by effectively substituting the bank's credit for the buyer's.
Letter of credit finance is not one-sided; it protects the buyer as well. The letter of credit will define certain terms that the seller must meet in order to receive payment from the bank. Common terms are the inclusion of specific shipping documents and the time frame in which the goods must be delivered.
There are different types of letters of credit available. For example, irrevocable letters of credit cannot be changed or cancelled unless every party agrees. Revocable letters of credit can be altered or cancelled by the issuing bank. There are also back-to-back letters of credit, confirmed and unconfirmed letters or credit, transferable letters of credit, and more.