What is a Letter of Credit and how does it work..??

A Letter of Credit is a type of Documentary Credit governed by UCP600 (Uniform Customs and Practice)..

ICC defines a Letter of Credit as

“A letter of credit is a promise by a bank on behalf of the buyer (customer/importer) to pay the seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller submits the required documents by a predetermined deadline.”

How does it work..??

In the beginning there is a seller and a buyer who want to conclude a business transaction..


They may or may not know each other or may or may not be comfortable with each other for 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..

Image for buyer and sellerThe 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..  


*** End of Article ***

19 thoughts on “What is a Letter of Credit and how does it work..??”

  1. Thank Sir, very clear info about letter of credit ,
    but in case, if the buyer fail to pay money to issuing bank , what will happen , how the money will be recover from buyer , as the bank have documents (B/L) ,bank is the owner of good now , can they take possession or how it will work further.

  2. We have delivered some items 6 moths before whereas customer’s willing to payment through LC as at present they don’t have any money. Is it valuable? What are the documents we have to submit the bank for release of payment as job is already completed? Your kind advise will be highly appreciated.

  3. Dear Mr. Manaadiar,

    Thanks so much for walking us through, on how LC works in such a simple and straight forward style.

    However, I just have some few points I’ll be pleased to get some clarifications on;
    1. Does the nominated bank pays the seller with it’s own fund before turning back to get paid from the Issuing Bank, or vice versa, or it all depends on whichever one the parties pre-agreed on?
    2. Does the issuing bank pays the nominated bank with it’s own fund before turning back to request payment from the applicant (the buyer), or vice versa or it all depends on whichever one the parties pre-agreed on?

    Thank you

    • Letter of Credit not received in our exporter bank, but cargo we sent at Nhava Sheva port. is it right?

  4. “A” Consult Ltd ordered a consignment of used clothes and shoes from P Fashions Ltd on a c.i.f. basis. The goods were shipped on 2 May 2013, and the shipping documents were received on 15 May 2013. Although payment was due upon receipt of the shipping documents, “A” Consult Ltd decided to wait for the arrival of the goods before making payment to their bankers, “C” Bank of INDIA, on letters of credit that were opened for the purpose.
    The goods arrived at the PORT on 31 May 2013, and upon taking delivery “A” Consult Ltd discovered that more than 50% of the clothes and shoes were too old to be sold. They have therefore refused to pay “C” Bank while they pursue a claim against P Fashion Ltd. Advise “C” Bank on their rights.

  5. is it possible that if the buyer trusts the seller, he asks for least documents as possible…


    are there some documents which are to be submitted mandately irrespective of the relationship between the buyer and the seller……….

    • For LC mode of payment, the payment terms between Buyer and Seller, usually within 7 days, 14 days and 21 days (maximum).
      For 90 days, I suggest you arrange T/T

  6. 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?

  7. 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.

    • First, i think the buyer will pay the issuing bank together when they issuing the LC.

      But, based on article above. The bank can always use his power to get the money back no matter what excuses the buyer gave.

  8. 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.

  9. 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.



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