Differentiate between letter of credit and bank guarantee. Why is Letter of credit mostly used in international trade? Explain. (NRB Questions)
Introduction
Are you prepared to explore the amazing world of international trade and discover the tiny but important differences between two of its most popular payment methods, my financially astute friend? We'll be examining the differences between a letter of credit and a bank guarantee today, as well as the reasons why the former rules the world of international trade. The snootiest banker at your next dinner party won't know what hit them, so sit back, relax, and get ready to master these terms!
Letter of credit (L/C)
The letter of credit (L/C) is one of the most frequently used legal instruments in international trade. A letter of credit is a sort of bank guarantee given by a bank or financial institution that enables a business to get paid right away for its debts even though it is only giving letters of credit to other banks or financial institutions. This kind of assurance has been used since ancient times, and it is still a valuable instrument for companies searching for ways to lower their risks in various cross-border transactions.
Particularly in the event of international trade, a financial institution will provide a letter of credit (L/C) to the exporter. It ensures that items will be paid for when they are delivered to the importer.
A letter of credit is mostly used to guard against fraud and loss brought on by delays, missed deliveries, or theft at ports or airports as commodities are transported from one nation to another. This document outlines the payment requirements for your shipment as well as the additional paperwork needed before an order can be processed via the customs clearance procedures at the destination port (s).
Difference Between LC and Bank Guarantee
Bank guarantee is a document issued by a bank or financial institution that allows an entity to obtain immediate payment of its obligations by issuing letters of credit only to other banks or financial institutions.
With a letter of credit provided only to other banks or financial institutions, a bank guarantee enables a firm to get quick payment of its debts.
A letter of credit is a type of payment used in international trade and finance that shows the issuing party has agreed to pay any party that has been paid on the document as long as specified requirements are satisfied. Letters may be written between two parties (such as a buyer and a vendor) or between one party and a number of other parties (such as those who have bought goods from another company). If there is no violation, the issuer must fulfill his or her commitment within 30 days of receiving it at the office from which he or she issued it. The issuer guarantees delivery against damage during transit or usage.
Payment guarantees are payments from one bank to another that must be made after the exporter has received payment for his goods.
After the exporter receives payment for his goods, payment guarantees are transfers of funds from one bank to another. Usually in the form of letters of credit, the bank guarantee is a document provided by a bank or financial institution that enables an organization to receive rapid payment of its debts.
Conclusion
The main difference between Letter of Credit and Bank Guarantee is that the bank guarantee covers all transactions in the country, while a letter of credit covers only one specific transaction.
Why is Letter of credit mostly used in international trade?
Risk Mitigation: There is always a chance that the buyer or seller won't fulfill their half of the contract when you engage in international trade. Due to the letter of credit's role as a contract between the buyer's bank and the seller, this risk is greatly diminished. As long as they uphold their half of the bargain, the seller can be sure that they will receive payment.
Flexibility: LCs can be altered to meet the particular requirements of each transaction. For instance, they might be set up to pay out a flat payment once the items are delivered, or they can be structured to distribute money in increments when the seller accomplishes particular goals.
Wide Acceptance: Banks all across the world recognize and accept LCs, making them a dependable and trusted payment option in the global economy.
Trade Financing: Numerous banks provide solutions for trade finance that are connected to LCs. As a result, a seller may be able to obtain money from the bank even before the products are delivered. This is advantageous for small firms since they do not have the cash flow to hold off on paying their suppliers.
Transparency: LCs give both the buyer and seller a clear set of instructions, which helps to prevent any misunderstandings or disagreements.
Around 80% of all international commerce transactions, according to the International Chamber of Commerce, require the usage of letters of credit. Around $2.8 trillion worth of LCs were issued worldwide in 2019. These figures highlight the significance of LCs in the context of global trade.
A letter of credit is, in essence, a dependable and commonly used form of payment that provides security, adaptability, and possibilities for trade financing. It makes sense that so many companies involved in foreign trade want to use LCs.
