A letter of credit is a document that a financial institution
or similar party issues to a seller of goods or services which provides
that the issuer will pay the seller for goods or services the seller
delivers to a third-party buyer.[1]
The issuer then seeks reimbursement from the buyer or from the buyer's
bank. The document serves essentially as a guarantee to the seller that
it will be paid by the issuer of the letter of credit regardless of
whether the buyer ultimately fails to pay. In this way, the risk that
the buyer will fail to pay is transferred from the seller to the letter
of credit's issuer.
Letters of credit are used primarily in international trade
for large transactions between a supplier in one country and a customer
in another. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version).[2]
They are also used in the land development process to ensure that
approved public facilities (streets, sidewalks, storm water ponds, etc.)
will be built. The parties to a letter of credit are the supplier,
usually called the beneficiary, the issuing bank, of whom the buyer is a client, and sometimes an advising bank,
of whom the beneficiary is a client. Almost all letters of credit are
irrevocable, i.e., cannot be amended or canceled without the consent of
the beneficiary, issuing bank, and confirming bank, if any. In executing
a transaction, letters of credit incorporate functions common to giros and traveler's cheques.
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