Letter of Credit – how it works

Image for buyer and sellerA Letter of Credit is a form of Documentary Credit governed by UCP (Uniform Customs and Practice) 600..

A letter of credit is basically a guarantee or promise by a bank on behalf of the buyer to pay the seller a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline..

This article explains in simple terms how a letter of credit works..

In the beginning there is a seller and buyer who want to conclude a business transaction.. Now they might or might not know each other or might or might not trust each other in terms of financial obligations..

Because of the time it takes for cargoes shipped from foreign ports to reach their destination, importers have to find a way of guaranteeing payment to exporters before the goods are received.. The answer is a letter of credit – an instruction by the importer’s bank to an overseas bank to pay the exporting company in advance.. The banks naturally charge interest for this service..

The buyer sets a list of terms and conditions under which he would like to buy and ship the cargo from the seller.. This list generally has

  • description of the goods he wants to buy from the seller
  • quantity of the goods
  • technical description if any
  • documentary requirements (bills of lading, commercial invoice, packing list etc etc)
  • details of the consignee (generally the issuing bank will be shown as the consignee and they will have control of the cargo until such time they receive the money from the buyer)
  • details of who must be notified of the arrival of the shipment
  • latest date of shipment
  • sometimes the buyer also nominates the shipping line that is to be used
  • which shipping ports are to be used
  • what mode of transport is to be used

Image for DocsThis L/C is then issued by the buyers bank (known as issuing bank) and is generally sent to the seller and his bank (known as the nominated bank)..

The seller than proceeds to prepare his goods and documents based on the L/C.. Once the shipment has been accomplished, the seller will take the copies of all the documents as per the instructions on the L/C to his bank.. His bank checks the veracity and correctness of the submitted documents against the L/C specifications..

Once the bank is satisfied that the docs and shipment are in accordance with the L/C, they pay the seller the money that is due to him as per the price agreed between him and the buyer..

The nominated bank, then sends all the docs to the issuing bank who cross verify the same and once they are satisfied with the conditions, they reimburse the receiving bank the money that they paid to the seller..

The issuing bank then advises the buyer that the shipment has been effected and that they are in possession of all the docs.. The buyer then arranges to pay the issuing bank the money that has been reimbursed by them to the receiving bank..

Image for moneyUpon receipt of these funds, the issuing bank then endorses the bill of lading so that the cargo can be released to the buyer..

So begins and ends the process of a Letter of Credit..

I would be interested to hear about any of your experiences (good or bad) with Letter of Credit, any disputes and how it was resolved etc.. If you have any, please do share for the benefit of all..  

 

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Now that you have read it, why don't you share your views about it..

14 thoughts on “Letter of Credit – how it works

  1. Mark says:

    Good Day tell me how would I protect myself if the seller says he gaurantees goods of the correct qualirty on arrival, can and will he only be paid once I have checked this?

    1. Hello Mark, what is your terms of sale with the seller..?? Have you done business with him before..??

  2. nadeesh says:

    very well explained and it is very clear. Thanks

  3. navin says:

    Dear Hariesh,
    how does the issuing bank protects its interests. Consider a case, where the buyer doesnt turn up to receive his cargo, possibly due to a sharp fall in the price of commodity. of course bank can take custody of cargo but the value of goods is less than what bank has paid.

  4. Albert Mhizha says:

    Hi Manaadiar,

    You aare really producing fantastic articles. Keep up the good work of educating people in this industry of ours. Once in shipping will remain in shipping. I would like you to comment of an FCA contract if you can. I would be happy if you could also elaborate on procedures or steps to take if i am say, of receiving and despatching a foreign vessel at port.

  5. rupa says:

    I have done diploma in shipping from india, but after marriage settle in singapore n busy with housework n kids
    almost 10yrs , i need to know some terms again like a revison n u have really provided it so well. as i m thinking to look for a job, but feel i lost confidence.

    thanks

  6. Gail says:

    Well done Hariesh! This is excellent! You should consider opening your own training company! You obviously have extensive knowledge and someone of your calibre would do very well in the SA industry! Kind regards, Gail

    1. manaadiar says:

      Hi Gail, thank you for your comments.. Am glad that i can be of assistance to anyone looking to enter the shipping industry..