What is Letter of Credit

Letter of credit, in a broad perspective, is one of the payment methods in international trade. 

Figure 1:  Payment Risk Diagram

Source : http://trade.gov/media/publications/pdf/tfg2008ch1.pdf 

We have explained above that letters of credit can limit the risks of importers and exporters. However, how can letters of credit achieve this? Letters of credit can balance the risks of exporters and importers because responsibility of LC operations is given to a third party, to the banks. We will explain this later on detailly.

Definition of Letter of Credit:

"Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation." (UCP 600, article 2)

This letter of credit definition is taken from the UCP 600 (ICC Uniform Customs and Practice for Documentary Credits) which is the latest version of the rules published by ICC (International Chamber of Commerce ) regulating the letters of credit operations all around the world. 

Role of the ICC and UCP in Letters of Credit

International trade is exchange of capital, goods, and services across international borders between people whom belong to different languages, cultures and laws. As letters of credit are a payment method of international trade it is obvious that standardized rules are needed to govern letters of credit in a global scale to make sure that letters of credit transactions run smoothly. ICC, International Chamber of Commerce, is the organization that publishes the standardized rules. The rules, which are called UCP, Uniform Customs and Practice for Documentary Credits, are revised regularly. At the time of this text is written sixth version of the UCP rules is in force.

In this first article, we have seen what letter of credit is, its definition, the rules that apply to them and the organization that publishes these rules. In the next article, we will examine types of letters of credit.

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Some of the other payment methods in international trade are Cash-in-AdvanceDocumentary Collections and Open Account. All of these payment methods inherit different risk levels for exporters and importers. Letters of credit is the only payment method, which has a balanced risk structure for both parties.  
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