Letter of Credit – how it works

This article is to provide in simple terms an explanation of how letter of credit works..

In the beginning there is a seller and buyer who want to conclude a business transaction.. Now they might or might not know each other or might or might not trust each other in terms of finiancial obligations..

Because of the time it takes for cargoes shipped from foreign ports to reach their destination, importers have to find a way of guaranteeing payment to exporters before the goods are received.. The answer is a letter of credit – an instruction by the importer’s bank to an overseas bank to pay the exporting company in advance.. The banks naturally charge interest for this service..

The buyer sets a list of terms and conditions under which he would like to buy and ship the cargo from the seller.. This list generally has

• description of the goods he wants to buy from the seller
• quantity of the goods
• technical description if any
• documentary requirements (bills of lading, commercial invoice, packing list etc etc)
• details of the consignee (generally the issuing bank will be shown as the consignee and they will have control of the cargo until such time they receive the money from the buyer)
• details of who must be notified of the arrival of the shipment
• latest date of shipment
• sometimes the buyer also nominates the shipping line that is to be used
• which shipping ports are to be used
• what mode of transport is to be used

This L/C is then issued by the buyers bank (known as issuing bank) and is generally sent to the seller and his bank (known as the nominated bank)..

The seller than proceeds to prepare his goods and documents based on the L/C.. Once the shipment has been accomplished, the seller will take the copies of all the documents as per the instructions on the L/C to his bank.. His bank checks the veracity and correctness of the submitted documents against the L/C specifications..

Once the bank is satisfied that the docs and shipment are in accordance with the L/C, they pay the seller the money that is due to him as per the price agreed between him and the buyer..

The nominated bank, then sends all the docs to the issuing bank who cross verify the same and once they are satisfied with the conditions, they reimburse the receiving bank the money that they paid to the seller..

The issuing bank then advises the buyer that the shipment has been effected and that they are in possession of all the docs.. The buyer then arranges to pay the issuing bank the money that has been reimbursed by them to the receiving bank..

Upon receipt of these funds, the issuing bank then endorses the bill of lading so that the cargo can be released to the buyer..

So begins and ends the process of a Letter of Credit..