An L/C or Letter of Credit is a document that is issued by your bank, or a bank that is acceptable to your supplier, undertaking that they will be paid after you have correctly shipped the goods ordered. It provides assurance to your supplier, and it provides assurance to you that you will not have to pay for goods not complying to the specifications required.
It is most often needed when your supplier is abroad and is not willing to take the risk that that you will pay promptly. It obviously does not apply if you need to pay in advance, or the 'goods' are virtual and instantly 'delivered' after payment.
The bank takes a risk on you, in that when it pays your supplier, you will have the resources to pay the bank back. That is why banks often requires up to 100% of the value of the L/C before they issue the L/C.
Following a trade contract between a buyer and a seller, the buyer approaches his bank (Issuing Bank) to issue an L/C to the advising bank in favor of the Seller. If the Issuing Bank is comfortable with the credit of the Buyer, it issues the L/C to the Advising Bank. Once, the supplier is informed of the L/C, to accepts the order and proceeds to complete the order. When the Supplier ships the goods and forwards the "Bill of Lading", evidencing shipment to the Advising bank, the Advising Bank, after checking the shipping documents, will pay the seller. The issuing bank will then pay the advising bank and draw the funds from the Buyer's account or will need to extend a short-term loan to the Buyer.
The Buyer pays for the L/C because it offers several benefits that allow or facilitate the transaction with the Seller. These include:
1. Risk Mitigation: Developing economies often face higher risks in international trade, such as political instability, weak legal systems, and creditworthiness concerns. LCs provide a secure mechanism for mitigating these risks by ensuring that payment is made only upon the fulfillment of specified conditions.
2. Credibility Enhancement: LCs enhance credibility for businesses in developing economies, especially when dealing with unfamiliar or less-trusted trading partners. By involving reputable banks as intermediaries, LCs provide assurance to both buyers and sellers that their interests will be protected, thereby facilitating trade.
3. Access to Financing: Developing economies often struggle with limited access to financing. LCs enable businesses to obtain trade finance from banks, allowing them to bridge the financial gaps and engage in international trade activities that would otherwise be challenging.
4. Standardization and Uniformity: LCs operate based on internationally recognized rules, such as those outlined by the International Chamber of Commerce (ICC) in their Uniform Customs and Practice for Documentary Credits (UCP). This standardization ensures a predictable and transparent framework for trade transactions, which is particularly valuable in developing economies with less-established legal systems.
5. Import and Export Facilitation: LCs simplify import and export processes by streamlining documentation requirements. By clearly defining the terms and conditions of the transaction, LCs help reduce disputes and delays, making it easier for businesses in developing economies to engage in international trade.
​
Hence, letters of credit are more prevalent in developing economies because they address the challenges faced by businesses in these economies. Businesses in Western countries, appear not to have these issues and do not appear to use L/Cs.
We guess that is why the current accounting or financial apps available take account of L/Cs.
Trafic recognizes the continuing need for L/Cs in developing countries and the need for trading businesses in these countries to work out what L/C faciities they need and how to quantify the facility they need to banks.