A Letter of Credit (LC) is a financial document used in international trade to facilitate the purchase of goods or services. It is essentially a commitment by a bank on behalf of a buyer (importer) to pay a specified sum to a seller (exporter) under certain conditions. Letters of Credit are commonly employed to reduce the risk of non-payment for the seller and to ensure that the buyer receives the goods or services as specified in the contract.
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How Letter of Credit Works?
Here’s how a Letter of Credit typically works:
Initiation
The buyer (importer) requests their bank to issue a Letter of Credit in favor of the seller (exporter).
Issuance
The buyer’s bank (issuing bank) issues the Letter of Credit, detailing the terms and conditions of the transaction.
Transmission
The Letter of Credit is typically transmitted through banks involved in the transaction. An advising bank, often located in the seller’s country, may be used to communicate the Letter of Credit to the seller.
Presentation of Documents
The seller ships the goods or provides the agreed-upon services and prepares the required documents, such as the invoice, bill of lading, and other relevant documents specified in the Letter of Credit.
Document Submission
The seller submits the documents to the bank, usually the advising or confirming bank, which then checks whether the documents comply with the terms and conditions of the Letter of Credit.
Payment or Acceptance
If the documents are in order, the bank makes the payment to the seller or accepts the draft, as specified in the Letter of Credit.
Key elements of a Letter of Credit
Issuing Bank
The bank that issues the Letter of Credit at the request of the buyer.
Advising Bank
The bank, often in the seller’s country, that communicates the Letter of Credit to the seller.
Applicant (Buyer)
The party who requests the issuance of the Letter of Credit.
Beneficiary (Seller)
The party to whom the Letter of Credit is addressed and who will receive payment.
Terms and Conditions
The specific requirements, including documents, shipping terms, and payment terms, that must be met for the Letter of Credit to be honored.
Letters of Credit come in various types, including revocable and irrevocable, confirmed and unconfirmed, and sight or time (usance) letters of credit. These variations impact factors like amendability, the level of risk for the seller, and the involvement of additional confirming banks.
Conclusion
Using a Letter of Credit provides a level of security to both the buyer and the seller, ensuring that payment is made when the agreed-upon conditions are met and that the seller fulfills their obligations as per the contract.
Also read: Bill of Lading, Its Purpose and Types
