Letter of Credit
A letter of credit is a bank's written guarantee that a buyer's payment to a seller will be made on time and in full, with the bank paying if the buyer cannot. Payment is triggered by the seller presenting compliant documents, not by the goods themselves. Letters of credit reduce counterparty risk in trade, especially cross-border, by substituting the bank's creditworthiness for the buyer's.
What a Letter of Credit Is
A letter of credit (LC) is a guarantee issued by a bank on behalf of a buyer, promising that the seller will be paid as long as the seller meets the stated conditions. If the buyer fails to pay, the issuing bank is obligated to. In effect, the bank's credit stands in for the buyer's, which is why letters of credit are a backbone of trade finance, particularly when buyer and seller are in different countries and do not know each other well.
How It Works
The mechanics follow a defined sequence. The buyer arranges for its bank (the issuing bank) to issue an LC in favor of the seller (the beneficiary). The seller ships the goods and presents the required documents, typically an invoice, a bill of lading, and any certificates, to the bank. If the documents comply exactly with the LC's terms, the bank pays. The critical point is that a letter of credit deals in documents, not goods: the bank pays against a compliant document presentation, and disputes about the goods themselves are separate from the bank's obligation to pay.
Common Types
- Commercial (documentary) LC. The primary payment mechanism for a trade, paid when compliant documents are presented.
- Standby LC. A backstop that pays only if the buyer defaults on its obligation, closer in function to a guarantee than a payment method.
- Confirmed vs unconfirmed. A confirmed LC adds a second bank's guarantee, often in the seller's country, for extra security.
- Sight vs usance. A sight LC pays on presentation; a usance (time) LC pays a set period later, effectively extending credit.
Why Businesses Use It
A letter of credit reduces risk on both sides of a trade. The seller gains confidence it will be paid, backed by a bank rather than an unfamiliar buyer, and the buyer gains assurance that payment is released only once the agreed documents (and, by extension, shipment) are in order. That risk reduction is what makes deals possible between parties that would otherwise be reluctant to extend or rely on open-account terms.
Where It Fits in Trade Finance
Letters of credit sit alongside other trade-finance tools. They are often used with purchase order financing, where a funder pays a supplier so a confirmed order can be fulfilled, and with supply chain finance and factoring further along the order-to-cash cycle. Each addresses a different point: the LC secures payment on a shipment, PO financing funds production, and factoring monetizes the resulting invoice.
How Zolvo Fits
Trade-finance lending is document-heavy and multi-party, exactly the work Zolvo automates: verifying counterparties and documents, tracking deals through fulfillment, and reconciling payments, on top of the systems a lender already runs. It applies across purchase order finance, supply chain finance, and factoring as one connected operation.
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