Transactions in the context of an agreement are a means to protect the interests of the parties involved. Letters of credit, albeit serving as a source of confidence for sellers when they do business with buyers, can be also regarded to assure a sense of security. This is because in addition to the promissory nature of the document there is also the institutional involvement in the transaction itself.
With the buying/selling mechanism getting subject to mediation by at least two banks — the issuing and the advising and/or confirming entities — the buyer can rely on the banks to execute the payment of the transaction and at the same time, the seller has a better sense of guarantee that the payment easily goes through. Credit is founded on the idea that sellers are guaranteed payment due to the presence of a financial/credit institution that pays on behalf of the seller; basically, the institution acts as a representation of the ability of payment, with the actual payment from the buyer becoming a matter between the buyer and the bank.
Evidently, in order to implement this, such transactions are governed by law and assured that the interests of those involved are protected. In looking at transactions involving letters of credit, the process in itself seems simple because the bulk of the work is executed by the contracted financial institutions. The letter of credit can be therefore considered as a more simplified means to facilitate business especially in cases of huge transactions; this explains why this document and process is a popular option in international trading scenarios.
However, there are the risks in the execution of letters of credit that businesses should take note of. First, there is the case of the possibility of fraud. Similar to credit-based transactions, letters of credit are not immune to fraudulent activities, although interestingly, as to be highlighted in the next sections of the paper, this may be due to the system letters of credit run in, thereby leading to this second issue: the role of the banks or the financial institutions involved in the process.
The financial institutions involved in the processing of the letter of credit are found to be limited in terms of their liability although it is in nature of the transaction that can cause the venues where fraud can take place. This shows that the institutional mechanisms of the letter of credit system are usually found irrelevant or outside certain developments that are fraudulent; this is mainly because the role of the banks are limited and the liability only extends to their function in the processing and the implementation of the document.
Outside that, such as fraud cases related to the sales agreement, the problem basically ends up between the seller and the buyer although basically it is the letter of credit that facilitated the agreement. Because of this, the system can be deemed questionable and can potentially jeopardise the interests of the buyer and the seller. Letters of Credit: an Overview Documents play an important role in financial transactions, and documents with a promissory nature can be regarded to contribute to the continuous dynamics of trade.
This therefore shows that in the financial aspect of any transaction, some agreements and even actual trading may take place without necessarily the presence of a cash lay-out. The nature of credit, albeit already a long-standing application in many forms of transactions, demonstrates how transactions may lie in a document or an element pertaining to a guarantee of payment. There are actually many types of credit, but depending on its intent and the capacity of use there are some preferred means to substitute actual payment with a form of document that reassures the beneficiary will be paid.
The fundamentals that support credit are based on a number of theories pertaining to the need to simulate the economy; one of these forces is the encouragement of international trade (Baker, 2003). Such is demonstrated in the theory of comparative advantage in which there is the notion that countries or economies can further experience improvement if it can produce more the goods it specialises in; through this continuous production activities efficiency emerges.
Another theory that motivates international trade is based on the economies of scale; this means that in order for the returns to increase costs can be cut down by through large-volume production and the distribution of the costs of the start-up. In addition, the theory also proposes that in order for the volume to increase, thereby reducing costs, companies should expand both domestic and international markets (Baker, 2003).
This is why although credit instruments such as the commercial letters of credit seems to be a sophisticated trading and financing tool that was created for the purpose of responding to the need to simulate and encourage vast economic activities especially at international levels, such tools have been in fact already present for centuries (Center for Research Foundation, 1999). Letters of credit, in its earlier forms, were also a popular means to facilitate trade based on the premise of the presence of a source of guarantee or a guarantor that actually has the capacity to pay on behalf of the buyer.
Today, letters of credit continue to play a significant role as global economic trade continues to grow and play an important role in creating such impacts at various economic levels. At this point it can be seen that there is a significant economic emphasis that motivates credit, but in order for credit arrangements to work, legal platforms are also used when it comes to making these business goals possible. This to say that credit at this degree spans beyond the establishment of agreement between and among parties, especially as the transaction can involve another institution that actually makes the transaction possible.
The entry of a financial institution such as a bank, and channels such as the letter of credit, can enable transactions even if the buyer does not really have the capacity to pay on the day the agreements were forged. Letters of credit are popular in international trading scenarios because this allows the buyer and the seller to initiate a transaction in a more convenient arrangement. The banks basically ensure that the payment for the goods sold is going to be in place.
Hence, the letter of credit serves as a tool that guarantees payment initiated by the bank on behalf of the buyer. The document has served as an important tool that binds an understanding between the two transacting parties with the involvement of a bank, the entity that provides the credit in this particular transaction. The issuing bank works as a guarantor in which the letter of credit issued can be received by the seller (on behalf of the seller’s bank) as the payment.