Conducting business transactions, especially across borders, doesn’t always go as smoothly as we’d like, with delays in payments, postponed shipments, and misunderstandings over contract terms being common occurrences for many buyers and sellers. International trade, in particular, adds extra layers of complexity due to differing regulations, currencies, and legal systems.
To navigate these challenges, individuals and entities alike rely on a powerful financial tool known as a letter of credit. This document serves as a promise from a financial institution, usually a bank, that payment will be made once the agreed-upon conditions are met. For businesses seeking flexible financial solutions beyond traditional banking, working with a licensed money lender in Paya Lebar like SG Licensed Money Lender can also provide alternative support, especially for bridging short-term cash flow gaps.
But how exactly does a letter of credit work, and why is it so essential to trade in Singapore and beyond? Let’s break it down.
What Is a Letter of Credit?
A letter of credit (LC) is a formal assurance from a bank that a seller will be paid in full and on time, as long as the conditions outlined in a sales agreement are satisfied. They can be likened to loan guarantors for regular loans. These conditions usually involve the presentation of certain documents, such as a bill of lading or proof of shipment.
In effect, the bank takes on the buyer’s financial obligation. This mitigates risks for both parties: sellers are assured of payment, and buyers only pay if the conditions of the deal are met. That’s why LCs are especially useful in international transactions where trust and legal recourse may be limited.
They also help insulate sellers from political and economic instability in the buyer’s country, since the risk is shifted to a (typically more reliable) bank. Because of these benefits, LCs are frequently used by international and even local businesses in Singapore.
Where LC Intersects with Domestic Finance
While LCs are commonly used in international trade, they also have relevance in local transactions in Singapore. For example, some businesses that regularly engage with high-value or high-risk clients use LCs for added assurance.
This is particularly useful for sellers dealing with new customers or those without a long track record of payment reliability. In fact, local businesses may also explore short-term financing options, such as an instant payday loan in Singapore, when waiting for LC payments to be released. While not directly related, this highlights how trade finance and consumer finance can occasionally overlap in practical settings.
The Step-by-Step Process of Using a Letter of Credit
Here’s a simplified version of how a letter of credit typically works:
1. The buyer (importer) arranges for a letter of credit through their bank, known as the issuing bank.
2. The issuing bank delivers the LC to the seller (exporter), usually via an advising bank in the exporter’s country.
3. The exporter sends the goods on their way and provides documentation, typically a bill of lading, to their advising bank.
4. Upon verification of the documents, the advising bank releases the payment to the exporter.
5. The advising bank submits the documents to the issuing bank for reimbursement.
6. The issuing bank forwards the documents as proof of shipment to the buyer, who then repays the issuing bank.
This system relies on precise documentation. Every detail, from shipment numbers to payment amounts, must match the terms of the LC exactly. Even minor discrepancies can lead to delays or denial of payment.
In Singapore, letters of credit are governed by the Uniform Customs and Practice for Documentary Credits, which is overseen by the International Chamber of Commerce in Singapore. Additionally, the Monetary Authority of Singapore regulates all financial institutions that issue these documents, ensuring compliance with trade financing laws.
Letters of Credit vs. Bank Guarantees
While both letters of credit and bank guarantees are forms of financial security, they serve different functions:
- A letter of credit ensures payment when the seller meets all specified conditions.
- A bank guarantee, on the other hand, is a fallback that activates only if the buyer defaults.
So, if you’re engaged in active trade, an LC is more proactive and assures performance. If you’re worried about buyer default on a larger project or loan, a bank guarantee offers protective coverage. Understanding the distinction can help businesses choose the right financial instrument based on their risk tolerance and business model.
How Much Does a Letter of Credit Cost?
Using a letter of credit does come at a cost, usually expressed as a percentage of the credit amount. In Singapore, average fees range from 0.75% to 1.5% of the total value of the transaction.
Here are some common charges involved:
- Issuance fees
- Opening charges
- Confirmation charges (if applicable)
- Advising or consulting fees
- Bank validation and courier fees
- Commitment fees for unutilised credit
Buyers usually shoulder most of these costs, although sellers may also incur bank handling and courier fees. It’s also common for banks to require an upfront deposit, typically a percentage of the transaction value, especially for clients with limited credit histories.
As such, businesses should factor in these charges when assessing the overall feasibility of a trade deal.
Common Types of Letters of Credit
Letters of credit come in various forms, each tailored for different trade purposes. Moreover, Businesses vary in size, financial stability, and trade agreements, so the availability of multiple credit letters is necessary to meet a variety of circumstances and requirements. Understanding their distinctions helps businesses choose the right one for their needs.
1. Commercial Letter of Credit (LC)
The most common type used in international trade, a commercial LC guarantees payment to the seller as long as they meet the terms outlined in the agreement—typically by submitting specific shipping and transaction documents. Also called a documentary credit, this LC protects sellers from buyer default and assures buyers that goods will be shipped as agreed. It’s issued by the buyer’s bank and widely used for one-time, cross-border trade deals.
2. Revolving Letter of Credit
Ideal for businesses with regular or repeat transactions, a revolving LC allows multiple payments over a set period without issuing a new LC each time. The credit amount resets after each use, streamlining the process and reducing administrative work. It can be structured based on time (e.g. monthly) or value limits. This type is useful for importers and exporters with long-term trade relationships and predictable shipping schedules.
3. Standby Letter of Credit (SBLC)
A standby LC serves as a financial safety net, ensuring the exporter gets paid if the buyer fails to meet their contractual obligations. While not used for routine payments, it reinforces trust in cases involving advance payments, ongoing contracts, or credit concerns. If the importer defaults, the issuing bank pays the seller upon proof of non-performance. It adds an extra layer of security to complex or high-risk deals.
4. Confirmed and Unconfirmed Letters of Credit
A confirmed LC involves a second bank—usually in the exporter’s country—that guarantees payment if the issuing bank defaults. This dual guarantee is useful when there’s uncertainty about the issuing bank’s reliability or the importing country’s stability. In contrast, an unconfirmed LC carries only the issuing bank’s promise. Most letters of credit are unconfirmed unless the exporter specifically requests added assurance.
5. Transferable Letter of Credit
This LC is used when the exporter acts as an intermediary between a manufacturer and an importer. It allows the exporter to transfer part or all of the credit to a secondary beneficiary (usually the manufacturer), while keeping the buyer’s identity confidential. Only one transfer is permitted, and it must be approved by both the issuing bank and the importer. It’s ideal for trade deals involving agents or brokers.
6. Back-to-Back Letter of Credit
When a transferable LC isn’t possible, back-to-back LCs offer a workaround. The exporter (middleman) uses the original LC from the buyer to secure a second LC in favour of the supplier. These are two separate but linked LCs. This structure allows the exporter to pay the supplier only after receiving assurance of payment from the buyer. It’s common in triangular trade and complex supply chains.
7. Irrevocable and Revocable Letters of Credit
An irrevocable LC cannot be cancelled or amended without consent from all involved parties, offering strong assurance for exporters. In contrast, a revocable LC allows the issuing bank to change or cancel the terms at any time without notice. However, modern letters of credit are considered irrevocable by default unless otherwise stated. Irrevocable LCs are preferred in most international transactions due to the security they provide.
8. Traveller’s Letter of Credit
A traveller’s LC enables individuals to withdraw funds from designated foreign banks while abroad, based on the terms set by the issuing bank. It’s primarily used by business travellers who need to make secure payments overseas. The letter is typically sold for cash and is useful for continuing trade transactions while away from home. Though less common today, it provides a formal method of accessing international banking support.
Pros and Cons of Using a Letter of Credit in Singapore
Advantages:
- Ensures a smooth, structured payment process.
- Encourages international trade for Singapore-based businesses.
- Transfers credit risk from buyer to bank.
- Helps define clear payment terms.
- Offers legal protection in case of disputes.
- Facilitates stronger supplier-buyer relationships.
Disadvantages:
- Only verifies documents, not the quality of goods.
- Time-sensitive—failure to act before expiry may forfeit payment.
- Errors in documentation can lead to delays or non-payment.
- Can be costly due to multiple fees and bank charges.
Letters of Credit in Singapore: A Tool for Strategic Trade
In Singapore, letters of credit have become a staple for both domestic and cross-border trade. Thanks to the country’s robust regulatory framework and global banking connections, businesses of all sizes can access LC services tailored to their needs.
Moreover, working with SG Licensed Money Lender can also be an alternative route for businesses seeking bridge financing while awaiting payment under an LC. This is particularly helpful for small enterprises with limited cash flow flexibility.
With the right documentation and partners in place, letters of credit offer one of the most reliable methods to safeguard transactions and foster trust in trade relationships.
Conclusion
Whether you’re a seasoned exporter or a first-time importer, understanding how letters of credit work can help you make informed decisions, protect your business, and unlock new trade opportunities. In a globalised economy where trust must be earned and verified, a letter of credit serves as a valuable instrument of assurance. When used properly, it empowers businesses to expand their horizons with reduced financial risk and greater confidence.
