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What Is a Letter of Credit?

A letter of credit (L/C) is a binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be transferred to the seller. Basically, a letter of credit gives the seller reassurance that he will receive the payment for the goods.

In order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the delivery of goods within a given time frame. An L/C is often used in international trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political instability.

In addition, a letter of credit is a banking mechanism which allows importers to offer secure terms to exporters. This mechanism is as follows:

● a payment undertaking given by the bank (the issuing bank)

● on behalf of the buyer (the applicant)

● to pay a seller (the beneficiary)

● a given amount of money

● on presentation of specified documents representing the supply of goods

● within specific time limits

● these documents conforming to terms and conditions set out in the letter of credit

● these documents to be presented at a specified place

Put simply, the issuing bank's role is twofold:

● to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller—the bank says in effect "We will pay you if you present documents (XYZ)".

● to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests—the bank says "We will only pay your supplier on your behalf if they present the documents (XYZ) that you have asked for".

Note that the letter of credit refers to documents representing the goods—not the goods themselves! Banks are not in the business of examining goods on behalf of their customers. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill and an insurance document; but there are many others.

The stages of the issuing a letter of credit:

1. The buyer and the seller reach an agreement on terms, including the means of transport, period of credit offered (if any) and latest date of shipment.

2. The buyer applies to his bank for issuing a letter of credit. The bank will evaluate the buyer's credit standing, and may require cash cover and/or reduction of other lending limits.

3. This bank (the issuing bank) issues an L/C, sending it to the advising bank by airmail or (more commonly) electronic means such as telex or SWIFT.

4. The advising bank establishes the authenticity of the letter of credit using signature books or test codes, then informs the seller (the beneficiary). The advising bank MAY confirm the L/C, i.e. add its own guarantee of payment.

5. The seller should now check that the L/C matches the commercial agreement and that all its terms and conditions can be satisfied (e.g. all documents can be obtained in good time). If there is anything that may cause a problem, an AMENDMENT must be requested.

6. The seller ships the goods and then assembles the documents detailed in the L/C (invoice, transport document etc.). Before presenting the documents to the bank, the seller should check them for discrepancies against the L/C and correct the documents where necessary.

7. The documents are presented to a bank, usually the advising bank. The advising bank checks the documents against the L/C. If the documents are compliant, the bank pays the seller and forwards the documents to the issuing bank.

8. The issuing bank now checks the documents itself. If they are in order (and it is a sight L/C), it reimburses the seller's bank immediately.

9. The issuing bank debits the buyer and releases the documents (including the transport document) so that the buyer can claim the goods from the carrier.

General Introduction about Terms of Payment

Just as in domestic trade, payment acts as a crucial role in the practice of international trade. However,  payment in international trade is more complicated in procedures,  owing to the fact that either party in a business transaction might have relatively limited knowledge of the financial strength and commercial reputation of his counterpart.

There are some commonly-used ways of payment in international trade, such as Letter of Credit (L/C), Documents against Payment (D/P), Documents against Acceptance (D/A), and so on. 

Each payment term has its own advantages and disadvantages. For instance, L/C, a conditional bank undertaking of payment, is conducted on banker's credit and guarantees the payment to the seller. Payment by D/P and D/A can lower the cost for the buyer, but might increase the risk of nonpayment to the seller. Therefore, both the seller and the buyer prefer to adopt the payment terms that are most beneficial to themselves. In this unit, we will read some dialogues about how to reach an agreement on terms of payment.