lettor of Credit

World of Finance by M.Vijaya Sai

Letter of credit (L/c) is the most preferred payment option for exporters. Compared to other payment options, L/c has many safeguards for sellers and at the same time assurance for buyers. It is usually issued by larger banks and contain a promise to pay a seller (beneficiary) upon receipt of goods by a buyer if certain conditions outlined in the letter have been met. 

What is Letter of Credit ?
Letter of Credit or (L/c) is a legal document to arrange payment between a buyer(importer) and seller (exporter). The bank, as intermediary, ensures security for both parties, giving the exporter confidence that the importer is capable of paying for the goods while assuring the importer that payment will be made to the exporter only after the terms outlined in the letter of credit have been met.

Analysis of typical L/c Transaction

Though a L/c can have great many variations (please see later part of this article) - for simplicity and ease of understanding, I have made a simple step-by-step description of a typical L/c transaction.

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  Step 1 After successful negotiation on price, specification, quality etc, Buyer selects a seller and places order for specified goods
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  Step 2 Seller accepts the order
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  Step 3 Buyer and Seller agrees on terms and conditions of the sale. Buyer instructs its bank to open a L/c incorporating previously agreed terms of sale
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  Step 4 The buyer's bank prepares a Letter of Credit (L/c), including all instructions to the seller's bank concerning the shipment and sends the L/c to the seller's bank, requesting confirmation. The seller may request confirmation from a confirming bank for added security.
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  Note: There are often delays at above two steps for various reasons like buyer does not have sufficient funds or seller requests change in L/c terms. Amendments are issued to incorporate changes in L/c terms.
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  Step 5 The Seller's bank prepares a letter of confirmation to forward to the seller along with the L/c. The seller reviews carefully all conditions in the L/c specially shipment schedule in consultation with his freight forwarder.
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  Step 6 The seller arranges the goods and hand over to freight forwarder for delivery at appropriate port or airport.
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  Step 7 Once goods are loaded/shipped, the forwarder completes necessary documentation and hand them over to the seller. The seller then presents the documents to his bank, informing full compliance with terms and conditions of L/c.
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  Step 8 The seller's bank reviews the documents. If they are in order, the documents are airmailed to the buyer's bank for review and passing necessary documents to buyer. The buyer gets the documents needed to claim the goods.
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  Step 9 The buyer's bank returns accepted draft and informs buyer. Buyer pays bank.
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  Step 10 The seller's bank gets payment and pays seller.

The letter of Credit Ensures that:
Payment to the seller will only be made after the terms of the L/c have been met. The documents, which have been reviewed by the bank's experienced staff, are in order. The seller is assured of the buyer's ability to pay and, as a result, a better price and more advantageous terms of payment may be offered.