In foreign trade the sellers and buyers of merchandise are confronted with greater risks than in domestic commerce, and so it is necessary for both parties to take measures for the protection of their interests. The exporter desires reimbursement as soon as he releases his goods, while the importer does not wish to make payment until he is sure that he will receive the goods which he has ordered. These ends are attained by the use of two documents known as the "authority to purchase" and the "letter of credit." By means of these instruments, the exporter is authorized to draw his drafts and is assured that they will be honored, provided he delivers documents evidencing the shipment of the goods ordered by the importer. The authority to purchase is issued by one bank instructing a second bank to buy the drafts drawn by the beneficiary on the importer, and thus the document gives rise to a trade bill. Ordinarily it could not well be sold, especially if drawn on a foreign firm whose credit standing is little known, but this difficulty is overcome, since the bank agrees with the exporter to buy his draft. Because of the restricted marketability of such trade bills, the authority to purchase is not used extensively, and in fact is limited to the financing of exports to the Far East.

The letter of credit has widespread application in foreign trade, for it aids the shipment of goods to all parts of the world. The letter of credit differs from the authority to purchase in that it instructs the beneficiary to draw his drafts not upon the importer, but upon a bank, thereby substituting its better-known credit for the limited reputation of the importer. The use of the letter of credit may be illustrated by tracing the financing of a shipment of merchandise. The American Importing Company of New York has ordered �1,000 worth of cotton goods from the British Exporting Company of London, and the two concerns have entered into a sales contract which specifies among other conditions that the importer must supply a banker's credit. The American firm thereupon requests a letter of credit from its New York bank, which first investigates the applicant's standing with the same care as in extending a loan. If his credit is considered satisfactory, the bank requests him to sign a contract in which the bank agrees to issue the letter of credit on behalf of the importer, who, on his part, promises to pay the commission for this service, to reimburse the bank for all outlays, and to pledge the merchandise as security.

The American bank, as credit issuer, may inform the British Exporting Company of the opening of the credit by delivering the letter to the importer, who mails it to the beneficiary. The American bank may also send its London correspondent a cable stating that a credit has been opened in favor of the British firm, and the London bank then transmits this information to the exporting company. Whether the credit is received by mail or by cable, the recipient immediately prepares the goods for export and forwards them to the seaboard, where they are placed on a vessel for New York. The exporting company then draws its draft upon the American credit-issuing bank and presents it for discount, together with shipping documents, to a British bank, usually the same one which has advised the credit. The documents are first compared with the letter of credit, and if the terms have been observed the draft is discounted. The negotiator then sends both draft and documents to its New York correspondent, which presents them to the credit-issuing bank. If it is a demand bill, the bank pays immediately, and receives reimbursement from the importer before giving him the shipment documents which are necessary for him to secure possession of the goods from the carrier. In the case of a time bill, the bank accepts it on behalf of the importer and gives him the documents usually after he has signed a trust receipt acknowledging that he is holding the merchandise merely as trustee for the bank. The importer then warehouses the material and later sells it to some one else, and the proceeds are delivered in an amount sufficient to place the bank in funds to cover the acceptances usually a day before their maturity.

As indicated in the above illustration, a letter of credit is the authorization addressed to the beneficiary by the credit-issuing bank, under which the former is instructed to draw drafts up to a specified sum and within a definite time upon the latter, which undertakes to honor the drafts if they are accompanied by certain documents. As this instrument in foreign trade is addressed by a bank to a seller located abroad, it is sometimes described as an "import" letter of credit. Where the information is transmitted through another bank in the same country as the beneficiary, the advice is called an "export" letter of credit.