What Is a Letter of Credit?

A letter of credit (LC) is a type of documentary credit operated according to UCP 600 (Uniform Customs and Practice). More specifically, it serves to prove that a bank promises or guarantees the payment of an established amount in an established currency by a buyer to a seller on condition that the latter submits the necessary documentation before a pre-established deadline. Here is a short introduction to what letters of credit are and how they work.

Let us assume that a business transaction is being negotiated between a seller and a buyer. The two parties may know and trust each other as far as the financial aspect is concerned or they may not. Now, it is a known fact that the transit times are rather extended when it comes to shipping any type of cargo from a foreign port. In this context, exporters must be provided with some kind of guarantee that they will get paid before the goods have reached their importer. This is where the letter of credit comes into play. This document provides the proof that the importer has arranged for the exporting company to get paid in advance. Typically, this service requires the payment of an interest.

The purchase and shipment of cargo by the buyer from the seller is conditioned by a set of terms and conditions which generally integrates the following pieces of information: general descriptions of the goods to be purchased, corresponding quantities to be acquired, technical descriptions of the goods to be purchased, all required documentation, details of the consignee (NB: Typically, the status is assigned to the issuing bank and ensures full control over the cargo until payment by the buyer is complete), details of the parties to be informed once the shipment has arrived, potential shipping deadlines, the shipping line to be used (on occasion), the shipping ports and modes of transportation used.

Once these terms and conditions have been established, the letter of credit is set up by the buyer's bank and forwarded to both the seller and the seller's bank, also identified as the nominated bank to allow the preparation of the goods and documentation. Copies of the entire documentation as stipulated in the letter of credit are then sent by the seller to their bank for verification. Once the verification process has been completed, the bank releases the money to the seller as per their agreement with the buyer. Next, the entire documentation is forwarded from the seller's bank to the issuing one for further verification and the receiving bank is reimbursed with the amount paid to the seller. Upon being informed on the shipment being effected and all documents being received by the issuing bank, the buyer releases the amount reimbursed by the issuing bank to the receiving bank to the former. Last but not least, a bill of lading is set up by the same issuing bank so as to allow the release of the cargo to the buyer.