Letter of Credit (LOC)

A Letter of Credit (also known as an 'LC' or 'LOC') is a formal promise from a bank, acting on behalf of a buyer, to pay a seller a specific sum of money. Think of it as a bank stepping in to guarantee a transaction. This payment is only released once the seller proves they have fulfilled their side of the bargain by presenting a specific set of documents, such as proof of shipment. Primarily a tool for international trade, an LOC brilliantly solves the trust issue between a seller in one country and a buyer in another. The seller doesn't want to ship valuable goods without being sure of payment, and the buyer doesn't want to pay until they know the goods are on their way. The LOC acts as a secure and reliable intermediary, replacing the buyer's creditworthiness with the bank's, thus ensuring both parties can proceed with confidence. It's the financial grease that keeps the wheels of global commerce turning smoothly.

Imagine you're a T-shirt maker in Portugal, and a new retail chain in the United States wants to place a huge order. You've never heard of them. Do you ship thousands of dollars worth of T-shirts across the Atlantic on a mere promise of payment? Probably not. The US retailer faces a similar dilemma: should they wire you a massive amount of cash, hoping you'll actually ship the goods? This is the classic “trust gap” in international trade. The Letter of Credit elegantly bridges this gap. The US retailer (the buyer) goes to their bank and applies for an LOC. The bank, after checking the retailer's finances and likely securing Collateral, issues the LOC. This letter is a legally binding commitment to you, the Portuguese T-shirt maker (the seller), that you will be paid as long as you meet the conditions laid out in the document. Now, you can start printing those T-shirts with peace of mind, knowing a reputable bank has guaranteed your payment.

Every LOC transaction involves a few key players. Understanding their roles is key to understanding the process:

• The Applicant (The Buyer): This is the party who requests the LOC from their bank. In our story, it's the US retail chain.
• The Beneficiary (The Seller): This is the party who will receive the payment once they comply with the LOC's terms. This is our Portuguese T-shirt maker.
• The Issuing Bank: The Applicant's bank. It issues the LOC and takes on the primary responsibility to pay.
• The Advising/Confirming Bank: Usually the Beneficiary's bank in their home country. It verifies that the LOC is authentic (advising) and may add its own guarantee of payment (confirming), providing an extra layer of security for the seller.

The process might sound complex, but it follows a logical sequence of steps designed to protect everyone involved.

1. 1. The Agreement: The buyer and seller agree in their sales contract to use an LOC as the payment method.
2. 2. The Application: The buyer applies for an LOC at their bank (the Issuing Bank), specifying all the terms, such as the required documents, shipping dates, and description of goods.
3. 3. The Issuance: The Issuing Bank approves the application and sends the LOC to the seller's bank (the Advising Bank).
4. 4. The Advice: The Advising Bank checks the LOC's authenticity and forwards it to the seller.
5. 5. The Shipment: Confident in the bank's guarantee, the seller ships the goods to the buyer.
6. 6. The Documents: The seller gathers the required documents, such as the commercial invoice, packing list, and most importantly, the Bill of Lading (which proves the goods have been handed over to the shipping carrier). They present these to their bank.
7. 7. The Payment: The banks meticulously review the documents. If every detail matches the terms of the LOC perfectly—a principle known as strict compliance—the Issuing Bank releases the funds. The seller gets paid.
8. 8. The Settlement: The Issuing Bank then turns to the buyer to collect the payment, completing the cycle.

While an LOC is an operational tool, not a direct investment product, understanding it provides valuable insight for an investor analyzing a company's health and risks.

A company's use of LOCs can tell a story. If a company is an exporter that consistently uses LOCs for its sales, it can be a sign of a robust and well-managed international operation. It shows they have a system for mitigating cross-border payment risk. Conversely, if a company (as a buyer) heavily relies on LOCs to purchase supplies, it's worth asking why. While it’s a standard risk management tool, it could also imply that its suppliers are unwilling to extend it Credit directly. This might not be a red flag on its own, but it's a detail that can add color to your analysis of the company's financial standing and its relationships within its supply chain.

For investors looking at banking stocks, the Trade Finance division is an important, often overlooked, source of revenue. Issuing LOCs generates fee income for banks, and it's generally considered a low-risk business because the loans are short-term and secured by the goods being traded. A bank with a strong and growing trade finance operation is likely well-managed, globally connected, and has a diversified, high-quality earnings stream—all attractive qualities for a value investor.