Letter of Credit (LC)

Letters of credit have been a cornerstone of international trade activity for many years. They provide one of the safest mechanisms to trade internationally and they often add the essential ingredient for confidence about payment. Letters of credit are used between the importer and the exporter whereby the letter of credit guarantees that the exporter will be paid by a major bank providing that the exporter can provide documents required under the letter of credit. The importer will not have to pay until the documents have been presented. It is a considerably secure method of payment as it replaces the unknown credit of the buyer with the unimpeachable credit of the Bank. The letter of credit can be clean or documentary. A clean letter of credit makes cash available on demand. Letters of credit used by traders are always documentary. This means that the exporter is required to produce documents stated in the letter of credit evidencing current shipment of the goods ordered before the money is released.

How it works

1. The importer and exporter conclude a sales contract which provides for payment through a letter of credit.
2. On the instructions of the importer, his bank (known as the issuing bank), prepares the credit in favour of the exporter. In doing so, the issuing bank must be satisfied as to the credit-worthiness of the importer.
3. The issuing bank asks a bank in the exporter's country to advise the credit to the exporter.
4. The advising bank informs the exporter that the credit has been issued and sends him the credit.
5. The exporter checks closely all the requirements of the letter of credit to see that they match the terms of agreement in the sales contract. If there are any discrepancies, they should be clarified immediately with the importer, and either the contract or the letter of credit should be amended so that they conform with each other.
6. Exporter despatches goods as specified in the credit to the importer.
7. The exporter presents the documents, together with a bill of exchange if called for, to the bank which has been nominated in the letter of credit as the paying/accepting/negotiating bank, (this is usually, although not necessarily, the advising bank).
8. The paying/accepting/negotiating bank checks the documents and, if they are in order, either pays the exporter (under a sight credit), accepts the bill of exchange for payment at a later date (under an insurance credit) or undertakes to pay at a later date (under a deferred payment credit).
9. The paying bank sends the documents to the issuing bank.
10. The issuing bank checks the documents and if they are in order reimburses the paying/accepting/negotiating bank, as arranged previously.
11. The importer pays the issuing bank the amount due or in terms, which have been agreed.
12. The issuing bank releases the documents to the importer.
13. The importer uses the documents to take delivery of the goods.