Letter of Credit (LC)

Definition: A Letter of Credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller, provided that the seller meets the terms specified in the LC. It protects sellers, often small and medium-sized enterprises (SMEs), from the risk of non-payment due to buyer default, insolvency, or bankruptcy. If such an event occurs, the process of claiming payment under the LC is known as liquidation. By submitting compliant documentation, the seller can receive payment from the issuing bank, maintaining cash flow and financial stability.

What Is a Letter of Credit?

A Letter of Credit is a commitment by a buyer’s bank to pay the seller upon fulfillment of specific conditions, typically the submission of agreed-upon shipping and commercial documents. Common in both domestic and international trade, LCs reduce credit risk and offer SMEs payment assurance in high-value or cross-border transactions.

Liquidation in the Context of LCs

Liquidation refers to the process of enforcing payment under an LC when the buyer defaults, becomes insolvent, or enters bankruptcy. As long as the seller complies with the LC’s terms, the issuing bank pays the agreed amount, safeguarding the seller from financial loss.

Why LC Liquidation Matters for SMEs

Trade Protection: Secures payments in uncertain or high-risk transactions.
Cash Flow Assurance: Guarantees receivables even if the buyer fails to pay.
Risk Mitigation: Shields SMEs from credit risk, currency volatility, and geopolitical disruptions.
Access to Financing: LCs can serve as collateral for trade or working capital loans.
Market Expansion: Enables SMEs to confidently engage with new or high-risk buyers.

LC Liquidation Process

Trigger Event: Buyer defaults or is declared insolvent.
Seller Action: Seller submits compliant documentation to their bank as per the LC terms.
Bank Review: Issuing bank verifies that all conditions are met.
Payment Release: Bank pays the seller, often backed by collateral or credit arrangements.
Record & Close: Transaction is documented, especially relevant for government-backed or SBA-supported trades.

Benefits of LC Liquidation

Improved Liquidity: Ensures timely payments despite buyer risk.
Reduced Bad Debt: Minimizes losses from uncollectible invoices.
Financing Leverage: Supports invoice financing and credit facilities.
Operational Confidence: Predictable revenue supports better planning.
Credibility Boost: Builds trust with larger or international buyers.

Example:

An Indian textile exporter used LCs to secure payments from European clients during economic turbulence.
SMEs with LC-backed transactions maintained steady operations through the COVID-19 crisis.
Southeast Asian manufacturers collected from struggling foreign buyers through LC liquidation—without legal intervention.

FAQs

1. What is a Letter of Credit and how does it work?

A Letter of Credit is a bank guarantee that ensures the seller gets paid if transaction terms are met. Once the seller provides the required documents, the bank pays on the buyer’s behalf.

2. When does LC liquidation occur?

Liquidation is triggered when the buyer defaults, becomes bankrupt, or enters insolvency. The seller then claims payment from the issuing bank.

3. Why is LC liquidation important for SMEs?

It protects cash flow, reduces risk, and enables SMEs to confidently deal with unfamiliar or foreign buyers.

4. Can SMEs get financing against an LC?

Yes. SMEs can use an LC as collateral to obtain pre-shipment or post-shipment financing without incurring new debt.

5. What does LC liquidation cost?

Banks typically charge 1.5%–8% of the LC’s value, depending on transaction complexity, risk profile, and terms.