How does Letter of Credit work?

What is Letter of Credit?

A Letter of Credit (LC), also known as a documentary credit, is a financial instrument commonly used in international trade to provide a secure method of payment and ensure that both the buyer and seller fulfill their obligations in a trade transaction. It involves the involvement of banks as intermediaries to minimize risks and ensure the smooth exchange of goods and funds. Here's how a Letter of Credit works:

1. Parties Involved:

Applicant (Buyer): The party initiating the Letter of Credit, usually the buyer/importer, who requests their bank to issue the LC on their behalf.
Beneficiary (Seller): The party to whom the LC is addressed, typically the seller/exporter, who will receive payment upon meeting the terms and conditions specified in the LC.
Issuing Bank: The buyer's bank that issues the Letter of Credit to the beneficiary and guarantees payment upon fulfillment of the LC's terms.
Advising Bank: The beneficiary's bank that receives and advises the LC to the beneficiary, ensuring its authenticity and informing the beneficiary about the terms.

2. LC Issuance:

The buyer and seller agree on the terms of the trade transaction, including the price, quantity, quality, delivery timeline, and any other relevant terms.
The buyer requests their bank (the issuing bank) to issue an LC in favor of the seller (the beneficiary).

3. LC Terms and Conditions:

The LC outlines the specific terms and conditions that must be met for the payment to be made. These may include:
Description of the goods and services to be provided.
Required shipping documents (bill of lading, invoice, packing list, etc.).
Price and currency of payment.
Delivery timeline and place.
Inspection or quality requirements.
Any other relevant conditions.

4. Shipment and Presentation of Documents:

The seller ships the goods and gathers the required documents as specified in the LC's terms.
The seller's bank (the advising bank) verifies the documents for compliance with the LC's terms and conditions.

5. Document Submission and Payment:

The seller submits the required documents to the advising bank or the issuing bank (as per the terms of the LC) within the stipulated time frame.
The bank reviews the documents and checks for compliance. If the documents meet the requirements, the bank will make payment to the seller.

6. Payment to Beneficiary:

Upon approval of the documents, the bank releases the payment to the beneficiary, according to the terms of the LC.

7. LC Settlement:

The issuing bank debits the buyer's account for the LC amount and related charges.

8. Document Discrepancies:

If the presented documents do not match the LC's terms or if there are discrepancies, the bank will notify the beneficiary. The beneficiary may choose to amend or correct the documents to rectify the discrepancies.

9. Dispute Resolution:

If there are disputes or disagreements regarding the documents, the parties may engage in negotiations or seek resolution through arbitration or legal channels.

In summary, a Letter of Credit provides a secure mechanism for international trade by ensuring that the seller is paid upon presenting compliant documents and that the buyer receives the specified goods and documents. It mitigates risks for both parties and facilitates cross-border transactions. However, it's important for both buyers and sellers to thoroughly understand the terms of the LC and work closely with their respective banks to ensure a smooth and successful trade transaction.

You can read more about all forms of LC in another page on the same website. A separate article has also been produced about the parties involved in the letter of credit.

When will the exporter be able to get funds under the LC?

The period of credit is determined by the terms agreed upon by the buyer and seller. The time to accomplish payment by the opening bank (buyer's bank) is set based on such credit period.

What is Sight LC, and how does it work?

Let us now look at the mechanics of working LC at sight. What is a sight letter of credit?

Procedures for obtaining funds under a Letter of Credit on the spot.

In the export sector, it is normal practice to open a Letter of Credit upon sight. Under sight LC, the payment of export revenues is made to the seller's bank by the buyer's bank immediately upon receipt of the original shipping documents in accordance with the terms and circumstances stated on the LC.

You can also read more information by clicking What are the advantages of Letter of Credit to Exporter? How LC is benefited to Importer? Are there any disadvantages to importer for a consignment under Letter of Credit? Who are the parties involved in Letter of Credit?

Yes, I am sure, once after going through that articles you will have a good knowledge about Letter of Credit.

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