Also abbreviated as ‘LOC’ or ‘LC’, a Letter of Credit is a document from a commercial bank or financial institution that guarantees a seller will receive a buyer’s payment on time and for the full amount. If this obligation is not met, the applicant’s issuing bank will pay the difference or cover it in full to the beneficiary.
A Letter of Credit is often used within the international trade industry on account of different laws in each country and the fact that those doing business often do not know each other personally. Therefore, before issuing a LC, the bank or financial institution will assess the applicant’s financial position to determine whether the client’s creditworthiness merits the risk taken on the applicant’s ability to pay. In some cases, the bank or financial institution may consider taking a security to minimise any potential loss.
When used by Islamic banks or financial institution, LCs are not treated as a guarantee but rather as a fee-based service to facilitate trade. Such LCs must Shariah-compliant on the basis of Wakalah, Murabaha or Musharakah.