A letter of credit (also known as documentary credit) is a document issued by a bank on behalf of an applicant (the buyer/customer) undertaking to make payment to a beneficiary (the seller/vendor) up to a stated amount of money, within a prescribed time limit and against stipulated documents. There are usually two banks involved in a letter of credit operation. The issuing bank is the bank of the buyer and issues the credit; the advising bank usually located in the sellers country receives the L/C.
Step-by-step description of a typical Letter of Credit transaction
1. An Importer (Buyer) and Exporter (Seller) agree on a purchase and sale of goods where payment is made by Letter of Credit.
2. The Importer completes an application requesting its bank (Issuing Bank) to issue a Letter of Credit in favour of the Exporter. Note that the Importer must have a line of credit with the Issuing Bank in order to request that a Letter of Credit be issued.
3. The Issuing Bank issues the Letter of Credit and sends it to the Advising Bank by telecommunication or registered mail in accordance with the Importer’s instructions. A request may be included for the Advising Bank to add its confirmation. The Advising Bank is typically located in the country where the Exporter carries on business and may be the Exporter’s bank.
4. The Advising Bank will verify the Letter of Credit for authenticity and send a copy to the Exporter.
5. The Exporter examines the Letter of Credit to ensure:
a) it corresponds to the terms and conditions in the purchase and sale agreement;
b) documents stipulated in the Letter of Credit can be produced; and
c) the terms and conditions of the Letter of Credit may be fulfilled.
6. If the Exporter is unable to comply with any term or condition of the Letter of Credit or if the Letter of Credit differs from the purchase and sale agreement, the Exporter should immediately notify the Importer and request an amendment to the Letter of Credit.
7. When all parties agree to the amendments, they are incorporated into the terms of the Letter of Credit and advised to the Exporter through the Advising Bank. It is recommended that the Exporter does not make any shipments against the Letter of Credit until the required amendments have been received.
8. The Exporter arranges for shipment of the goods, prepares and/or obtains the documents specified in the Letter of Credit and makes demand under the Letter of Credit by presenting the documents within the stated period and before the expiry date to the “available with” Bank. This may be the Advising/Confirming Bank. That bank checks the documents against the Letter of Credit and forwards them to the Issuing Bank.
9. The Issuing Bank examines the documents to ensure they comply with the Letter of Credit terms and conditions. The Issuing Bank obtains payment from the Importer for payment already made to the “available with” or the Confirming Bank.
10. Documents are delivered to the Importer to allow them to take possession of the goods from the transport company. The trade cycle is complete as the Importer has received its goods and the Exporter has obtained payment.