A commercial letter of credit is used during business transactions, usually — but not always — between international parties, to promise payment in return for products or services. Just like other types of letters of credit, this document explicitly details how much money will be paid to the business providing the product or service. This letter is made by the customer’s bank as a way of authorizing a second bank to pay the seller. To receive payment, the seller must show the bank documents that confirm services are complete or shipped; otherwise the bank will not release payment. With a commercial letter of credit, the issuing bank replaces the buyer as the payee; if there are problems with payment, the seller goes to the issuing bank instead of to the buyer.
All letters of credit are documents that promise and authorize payment, and they are created by the bank representing the buyer, known as the issuing bank. In a commercial letter of credit, the letter specifies what the buyer is receiving, the time limit for payment, which bank will pay the seller, and how much is being paid for the services. The buyer, to secure payment to the seller, initiates the letter.
The buyer goes to his or her bank and asks for a commercial letter of credit to be created. After it is written, the letter is sent to the seller’s bank, known as an advising bank, where the letter is authorized. When the terms of the letter are satisfied, the advising bank will release payment.
A commercial letter of credit differs from others mostly on the payment terms for the seller. Unlike other letters of credit, the seller has to show proof that the products have been shipped or that a service is complete. If proof cannot be rendered, then the advising bank will refuse payment until it can be. While this means the seller will have to wait longer to receive payment, it protects both parties from potential fraud.
When a commercial letter of credit is created, the buyer is no longer the payee and has no financial obligation to the business transactions; this is because the buyer supplies all the money needed for the letter when it is created. The issuing bank becomes the payee, because the issuing bank is in control of the money. If there are problems with the transaction, the seller has to deal directly with the bank, not the buyer.