Letter of Credit Mechanism

To understand the letter of credit mechanism, it is very important that we first understand what a letter of credit is and why it is used.

Letter of Credit – Meaning & Origination

International trade is not a new concept to the world. Since the day humans started establishing state boundaries, international trade has been taking place. The industrial revolution in the 18th century saw a rise in international trade, and the availability of various tools gave rise to professionalism in international trade. The letter of credit as we know it today has gained its popularity in the early 19th century. It is a payment instrument used in cross-border transactions. The basis of this instrument is that the bank becomes a bridge between the buyer and the seller, assuring that both the parties fulfill their obligations.

A letter of credit helps in establishing trust and confidence in conducting business internationally, where the distance from the home country, laws & custom rules of the foreign land, etc. can prove to be a hurdle.

Letter of Credit Mechanism

Entities of a Letter of Credit

Firstly, let us understand the basic entities who are involved a letter of credit

  • Applicant – The entity who applies for the letter of credit. This is usually the buyer i.e. the importer
  • Beneficiary – The entity for whom the letter of credit is issued. On completion of the transaction, the beneficiary receives the payment. This is normally the seller i.e. the exporter
  • Issuing Bank – This is the bank that issues the letter of credit. This is usually a bank whose branch is located in the applicant’s home country.
  • Advising Bank – This is the bank that advises the beneficiary throughout the process of the letter of credit.

These are the four basic entities who are always involved in a letter of credit. There may or may not be the involvement of following entities depending on the type of letter of credit:

  • Confirming Bank – This entity in involved only when a letter of credit is a confirmed letter of credit. This is the bank who gives additional confirmation of fulfillment of obligation over and above the guarantee by issuing bank.

Process of a Basic Regular Letter of Credit Transaction

Following is the process of a documentary letter of credit:

A buyer from France decides to buy goods of USD 5000.00 from a seller in Malaysia by documentary letter of credit. The buyer asks his bank i.e. the issuing bank to issue a letter of credit in the name of the seller.

  • Issuing bank issues a documentary letter of credit in the name of the seller and keeps the seller’s bank as advising bank.
  • Seller manufactures and ships the goods to the buyer and prepares all the documents.
  • The seller submits the documents to the advising bank, who checks the documents for discrepancies, and if no discrepancies are found, they send the documents to the issuing bank.
  • Issuing bank checks the documents and if found satisfactory, intimates the buyer of the same.
  • The buyer makes complete payment of USD 5000.00 plus the bank charges to the issuing bank. After receiving the payment, the issuing bank gives the documents to the buyer.
  • The buyer clears the goods from the shipping line through these documents.
  • The issuing bank transfers full payment of USD 5000.00 to the advising bank.
  • Advising bank deducts its own service charge and transfers the remaining payment to the seller.

Thus the transaction is complete.

Types of Letter of Credit

There are many types of letter of credit to suit the requirements of various types of cross-border transactions. Most commonly used letter of credit are –

Documents Required in a Letter of Credit

As mentioned in the process of the letter of credit the seller should send some documents to the buyer before he receives the payment for the goods supplied. These documents include following –

  • Invoice
  • Packing List
  • Bill of Lading
  • Insurance
  • Bill of Exchange
  • Inspection certificate/ Certificate of Origin/ Duty waiver certificates, etc. if required

Each letter of credit is unique and the buyer has the liberty to choose which documents the seller has to submit to complete the transaction. There are some custom laws that make certain documents mandatory, but other documents are optional.

Cost of a Letter of Credit

The issuing bank can charges an issuance fees and an interest from the applicant for issuing the letter of credit. On the other hand, the advising bank charges their advising fees from the beneficiary.

Last updated on : October 6th, 2018

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