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What is a Letter of Credit


A letter of credit is a banking mechanism which allows importers to offer secure terms to exporters.

All letters of credit contain these elements:

  • a payment undertaking given by the bank (issuing bank);

  • on behalf of the buyer (applicant);

  • to pay a seller (beneficiary);

  • given amount of money;

  • on presentation of specified documents representing the supply of goods;

  • within specific time limits;

  • these documents conforming to terms and conditions set out in the letter of credit;

  • documents to be presented at a specified place.

Put simply, the issuing bank's role is twofold:

  • to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller - the bank says in effect "We will pay you if you present documents (XYZ)"

  • to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests - the bank says "We will only pay your supplier on your behalf if they present documents (XYZ) that you have asked for"

Note that the letter of credit refers to documents representing the goods - not the goods themselves! Banks are not in the business of examining goods on behalf of their customers.

Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; but there are many others.

Letters of credit deal in documents, not goods.

The stages of the letter of credit

  1. Buyer and seller agree terms, including means of transport, period of credit offered (if any), latest date of shipment, Incoterm to be used.
  2. Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit standing, and may require cash cover and/or reduction of other lending limits.
  3. Issuing bank issues L/C, sending it to the Advising bank by airmail or (more commonly) electronic means such as telex or SWIFT
  4. Advising bank establishes authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). Advising bank MAY confirm L/C, i.e. add its own payment undertaking
  5. Seller should now check that L/C matches commercial agreement, and that all its terms and conditions can be satisfied, (e.g. all documents can be obtained in good time). If there is anything that may cause a problem, an AMENDMENT must be requested.
  6. Seller ships the goods, then assembles the documents called for the L/C (invoice, transport document etc.) Before presenting the documents to the bank, the seller should check them for discrepancies with the L/C, and correct the documents where necessary.
  7. The documents are presented to a bank, often the Advising bank. The Advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the Issuing bank.
  8. The Issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the seller's bank immediately.
  9. The Issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.

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