Letter of Credit - Process

The entire process under LC consists of four primary steps:

Step 1 - Issuance of LC

After the parties to the trade agree on the contract and the use of
LC, the importer applies to the issuing bank to issue an LC in favor of
the exporter. The LC is sent by the issuing bank to the advising bank.
The latter is generally based in the exporter’s country and may even
be the exporter’s bank. The advising bank (confirming bank) verifies
the authenticity of the LC and forwards it to the exporter.

Step 2 - Shipping of goods

After receipt of the LC, the exporter is expected to verify the same
to their satisfaction and initiate the goods shipping process.

Step 3 - Providing Documents to the confirming bank

After the goods are shipped, the exporter (either on their own or
through the freight forwarder) presents the documents to the
advising/confirming bank.

Step 4 - Settlement of payment from importer and possession of

goods

The bank, in turn, sends them to the issuing bank and the amount is
paid, accepted, or negotiated, as the case may be. The issuing bank
verifies the documents and obtains payment from the importer. It
sends the documents to the importer, who uses them to get
possession of the shipped goods.

Letter of Credit with Example

Suppose Mr A (an Indian Exporter) has a contract with Mr B (an
importer from the US) for sending a shipment of goods. Both parties
being unknown to each other decide to go for an LC arrangement.

The letter of credit assures Mr A that he will receive the payment

from the buyer and Mr B that he will have a systematic and
documented process along with the evidence of goods having been
shipped.

From this point on, this is how a letter of credit transaction would
unveil between Mr A & Mr B:-

 Mr B (buyer) goes to his bank that is the issuing bank (also

called an opening bank) and issues a Letter of Credit.

 The issuing bank further processes the LC to the advising bank

(Mr A's bank).

 The advising bank checks the authenticity of the LC and sends

it to Mr A.

 Now that Mr A has received the confirmation he will ship the

goods and while doing so he will receive a Bill of Lading along
with other necessary documents.

 Further, he will send these documents to the negotiating bank.

 The negotiating bank will make sure that all necessary

requirements are fulfilled and accordingly make the payment
to Mr A (the seller).

 Additionally, the negotiating bank will send all the necessary

documents to the issuing bank.
  Which again the issuing bank will send to Mr B (Buyer) to
confirm the authenticity.

 Once Mr B has confirmed he will make the payment to the

issuing bank.

 And the issuing bank will pass on the funds to the negotiating
bank.

To understand the process clearly refer to this image:

Letter of credit Sample Format

 Red Clause LC
 Green Clause LC
To understand each type in detail read the article, Types of letter of
credit used in International Trade .

Bank guarantee vs letter of credit

A Bank guarantee is a commercial instrument. It is an assurance

given by the bank for a non-performing activity. If any activity fails,
the bank guarantees to pay the dues. There are 3 parties involved in
the bank guarantee process i.e the applicant, the beneficiary and
the banker.
Whereas, a Letter of Credit is a commitment document. It is an
assurance given by the bank or any other financial institution for a
performing activity. It guarantees that the payment will be made by
the importer subjected to conditions mentioned in the LC. There are
4 parties involved in the letter of credit i.e the exporter, the
importer, issuing bank and the advising bank (confirming bank).

Letters Of Credit – Definition, Types & Process

 
A Letter of Credit (LC) is a document that guarantees the buyer’s
payment to the sellers. It is issued by a bank and ensures timely and
full payment to the seller. If the buyer is unable to make such a
payment, the bank covers the full or the remaining amount on behalf
of the buyer.

A letter of credit is issued against a pledge of securities or cash.

Banks typically collect a fee, ie, a percentage of the size/amount of
the letter of credit.

Importance of Letters of Credit

Since the nature of international trade includes factors such as

distance, different laws in each country and the lack of personal
contact during international trade, letters of credit make a reliable
payment mechanism. The ‘International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits’ oversees
letters of credit used in international transactions.
Parties to a Letter of Credit

 Applicant (importer) requests the bank to issue the LC.

 Issuing bank (importer’s bank which issues the LC [also
known as the Opening banker of LC]).
 Beneficiary (exporter).

Types of a Letter of Credit

The letters of credit can be divided into the following categories:

Sight Credit

Under this LC, documents are payable at the sight/ upon

presentation of the correct documentation. For example, a
businessman can present a bill of exchange to a lender along with a
sight letter of credit and take the necessary funds right away. A sight
letter of credit is more immediate than other forms of letters of
credit.

Acceptance Credit/ Time Credit

The Bills of Exchange which are drawn and payable after a period,
are called usance bills. Under acceptance credit, these usance bills
are accepted upon presentation and eventually honoured on their
respective due dates.

For example, a company purchases materials from a supplier and

receives the goods on the same day. The bill will be delivered with
the shipment of goods, but the company may have up to 30 days to
pay it. This 30 day period marks the usance for the sale.

Revocable and Irrevocable Credit

A revocable LC is a credit, the terms and conditions of which can be

amended/ cancelled by the Issuing Bank. This cancellation can be
done without prior notice to the beneficiaries. An irrevocable credit
is a credit, the terms and conditions of which can neither be
amended nor cancelled. Hence, the opening bank is bound by the
commitments given in the LC.

Confirmed Credit

Only irrevocable LC can be confirmed. A confirmed LC is one when a

banker other than the Issuing bank, adds its own confirmation to the
credit. In case of confirmed LCs, the beneficiary’s bank would submit
the documents to the confirming banker.

Back-to-Back credit: In a back to back credit, the exporter (the

beneficiary) requests his banker to issue an LC in favour of his
supplier to procure raw materials, goods on the basis of the export
LC received by him. This type of LC is known as Back-to-Back credit.

Example: An Indian exporter receives an export LC from his overseas

client in the Netherlands. The Indian exporter approaches his banker
with a request to issue an LC in favour of his local supplier of raw
materials. The bank issues an LC backed by the export LC. 

Transferable Credit: While an LC is not a negotiable instrument, the

Bills of Exchange drawn under it are negotiable. A Transferable Credit
is one in which a beneficiary can transfer his rights to third parties.
Such LC should clearly indicate that it is a ‘Transferable’ LC.

Format of LC