Letters of credit and escrow services work similarly in facilitating the trade deals. Both instruments offer a financial guarantee to both parties in a trade deal. Transactions with large financial values are a riskier option and often require third-party guarantors.
Two parties in a domestic or international trade deal can seek expertise from third-party institutes. The main objective of seeking help from third-party service providers is to reduce the financial risk and facilitate the trade deal. Once a trade deal is finalized, both parties can opt to use a letter of credit as means of payment. Another option is to use an escrow agent that facilitates the payment.
Escrow is a financial arrangement between two parties where a third-party service provider holds the payment until the trade deal terms are met by both parties.
The escrow service providers receive the deal payments from the buyers and keep the funds until the seller fulfills the requirements. The escrow agent aims to facilitate both parties in the trade deal.
Escrow is essentially used as a secure mode of payment in a trade deal through a third-party service provider.
Letter of Credit
A letter of credit is a promise of payment from the issuing bank to the beneficiary on behalf of the applicant. LC is issued by banks for the applicants in favor of the beneficiary (exporters). It guarantees the payment to the exporter from the bank if the importer defaults on the payment.
LC can take several types and embed different features. Thus, it can facilitate both parties in a trade deal. There are usually at least two banks involved in a letter of credit arrangement.
LC can be used as a mode of payment; however, its prime objective is to provide financial security to both parties in a trade deal.
For practical functions, a letter of credit and escrow services act similarly. Both parties agree on a trade deal and decide a payment mechanism. They can choose an LC or escrow services.
Escrow Services Working Mechanism
Both parties come to an agreement on a trade deal and finalize the terms and conditions. Both parties would like to secure their interests before the deal is closed. The buyers look to inspect the goods (or services) quality and quantity before making a payment. The sellers would seek financial security with a trade deal. Both parties can agree to use it through a specialist.
An escrow agent office will receive funds from the buyer (importer) and hold the fund until the trade terms are completed. The agreement must provide full details on the trade terms, exact amount, payment date, and legalities before the payment is released. Once the exporter ships the goods, it can contact the escrow agent for the release of funds. The buyer will issue the confirmation to the escrow agent for releasing the payment.
Letter of Credit Working Mechanism
If both parties agree on an LC as a mode of payment, the buyer (importer) will apply with a bank. Unlike an escrow, the bank will assess the creditworthiness of the applicant. Once approved, the bank will issue a letter of credit in favor of the beneficiary.
Once the exporter receives confirmation of a letter of credit, it can start processing the goods. The sellers can demand the payment as soon as goods are shipped. The LC will also include the terms and conditions of the shipment of goods before the payment is cleared by the bank.
A distinction of an LC is the flexibility and the availability of several features through banks. A letter of credit can take several types and embed different features such as confirmation, transferability, irrevocability, and funding that secures the interests of both parties in the trade deal.
When to use Escrow
Escrow services provide great financial security to both parties in a trade deal. Escrow services are mostly used in the real estate sector. The agents can hold the funds until the buyer completes the inspection and legal procedures of the property.
Escrow is particularly beneficial in domestic trade deals with large transaction values. It is less complicated than a letter of credit. Escrow services providers can be banks, financial institutes, or private companies. Thus, such services are useful for many companies with available resources.
When to use a letter of Credit
A letter of credit not only comes as a payment option, but it also offers great financial security to both parties in a trade deal. Letters of credit are commonly used in international trade agreements. As it involves at least two banks, it’s a fairly secured instrument than escrow services.
A letter of credit can take several types by embedding different features. It is a fairly complex and costly arrangement. It requires the good creditworthiness of the applicant. Hence, it should be used in large and complex international trade deals.
Pros and Cons of using Escrow
Escrow services come with their pros and cons as compared with a letter of credit.
Pros of Escrow Services:
- This arrangement reduces the default risk of the buyer in a large transaction.
- It also serves the buyer for the quality and quantity of the delivered goods or services.
- It facilitates trade deals with large transaction values.
- The escrow agent oversees the full transaction cycle from receiving funds in the escrow account, delivery of the goods, and confirmation of the deal closing.
Cons of using Escrow Services:
- An escrow office can work only as a trade deal facilitator.
- The agent cannot forfeit or seize the funds in the escrow account that makes the arrangement less reliable than guarantees and letters of credit.
- Both parties need to agree on an escrow office.
- The third-party services can also be risky if the service provider is not reliable.
Pros and Cons of a Letter of Credit
A letter of credit is a formal and complex arrangement than using escrow services. However, it has many advantages as compared to escrow services.
- It provides a financial guarantee to both parties in a trade deal, unlike escrow.
- The bank assesses the credibility of the applicant and may oversee the full trade deal before releasing the payment.
- It facilitates large international trade deals with a complex payment structure.
- Both parties can embed different features as a letter of credit is a highly customizable feature.
Cons of a Letter of Credit
- A letter of credit is an expensive and complex arrangement than escrow.
- It may not be accessible for small companies with bad credit history.
- It does not fully mitigate the default risk of the applicant.
Escrow services and letter of credit both provide good options to both parties in a trade deal. Escrow comes with an advantage of upfront payment to the third-party, hence reduces the default risk of the buyer. A letter of credit is a formal and legally secured instrument than escrow services.