Letter of Credit | Payment Terms in International Trade

L/C, short for “Letter of Credit”, is a contractual payment instrument that guarantees the importer’s payment to the exporter when the exporter ships the goods to the importer in conformity with the terms and conditions in the sales contract and presents the required export documents to the advising bank.

Although Letter of Credit is a costly and arduous method of payment compared to other payment terms, it’s a commonly used one in international trade. It is preferred especially between the parties who don’t know each other, don’t trust each other, don’t have a business background or when the goods in question are of high value. In such a case, it’s the only payment method that protects both parties from a failure of transaction.

If the exporter doesn’t fulfill its obligations to the importer to ship the goods under the agreed conditions, it is not paid. The importer, on the other hand, cannot withdraw the goods from the customs if it doesn’t make the payment. Furthermore, depending on the type of Letter of Credit (for example; in the case that it is a confirmed L/C); if the exporter has fulfilled its obligations and presents the required documents to the beneficiary or confirming bank, it is paid howsoever.

Parties involved in L/C

Applicant: An applicant is the importer that wants to buy from the exporter. It requests its bank to issue a letter of credit.

Issuing bank: Issuing bank is the importer’s bank that issues the letter of credit on the importer’s behalf. 

Beneficiary: Beneficiary is the exporter that receives the payment.

Advising Bank: Advising bank, also known as notifying bank, is the exporter’s bank that notifies the exporter (beneficiary) that an L/C has been opened by the issuing bank (importer’s bank).

Confirming Bank: In the case that the letter of credit is confirmed, the confirming bank is responsible to add its confirmation to the L/C in question.

Reimbursing Bank: If the amount is paid by a third bank to the confirming bank on behalf of the issuing bank, the third bank here is called the reimbursing bank.

Types Of Letter of Credit

  • Irrevocable L/C
  • Confirmed L/C
  • Unconfirmed L/C
  • L/C At Sight
  • Deferred L/C
  • Transferable L/C
  • Back to Back L/C
  • Standby L/C
  • Red Clause L/C
  • Green Clause L/C
  • Revolving L/C

How Letter of Credit Works

Letter of Credit Process in 8 Steps

  1. The parties sign a contract agreeing on a certain type of L/C as a payment method.

  2. The importer (applicant) goes to its bank (issuing bank) and applies for issuing an L/C with a list of terms and conditions.

  3. The issuing bank sends the L/C to the exporter’s bank (advising bank).

  4. The advising bank checks and verifies the authenticity of the L/C and notifies the exporter.

  5. After receiving the L/C, the exporter verifies it, makes the goods ready for export and ships them to the importer. When the exporter collects the required documents including B/L, it presents them to the advising bank.

  6. Advising bank checks the authenticity of the submitted documents and forwards them to the issuing bank (If it’s a confirmed L/C, the advising/confirming bank makes the payment at that moment).

  7. Once the issuing bank gets the documents, it checks them again. Upon verification of the documents, the issuing bank reimburses the money to the advising bank to be released to the exporter.

  8. Upon receipt of the funds, the issuing bank releases the documents to the importer so it can clear the goods at the customs.

Careful

In an L/C process you have to do the work right. Study the documents, terms and conditions. Otherwise it’ll be difficult to make up for the documentation and operation process. Besides, you’ll have to pay for a number of compensation, demurrage and penalties. 

Take some time to peruse the contract and letter of credit. If you are not experienced in working L/C don’t hesitate to work with your bank during the process closely.

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