Letter of Credit

A letter of credit (LC) or documentary credit is a means of payment in a trade transaction that commits the issuer, usually a commercial bank, on behalf of its customer, a buyer, to pay a seller contingent on documentary evidence that the seller has met the terms and conditions of the letter of credit. A letter of credit is commonly used in international trade. A seller (exporter) who does not wish to risk nonpayment by a buyer (importer) may require the issuance of a letter of credit by the buyer's bank as a condition of the sale. In a letter-of-credit transaction, the issuing bank's credit risk is substituted for the credit risk of the buyer that is otherwise assumed by the seller whenever transactions are conducted on open account terms. The letter of credit serves as a method of payment when informational asymmetries exist about the buyer's capacity to pay.

Process

A commercial letter-of-credit transaction involves six steps: (1) after a sales contract has been negotiated that requires a letter of credit, the buyer or applicant applies to its bank to issue the letter of credit, committing the bank to pay the seller or beneficiary upon the receipt of specified documents, such as a bill of lading and a draft drawn by the seller demanding payment, before the expiration of the letter of credit; (2) the issuing bank then requests a correspondent bank in the seller's vicinity to advise the seller that a letter of credit has been issued in its behalf; (3) and (4) upon this advice from the advising bank, the seller arranges to ship the goods and then submits the required documents called for in the letter of credit to a local bank that serves as the negotiating bank, receiving and examining the documents for compliance with the terms and conditions of the letter of credit and then forwarding them to the issuing bank; (5) the issuing bank also examines the documents for compliance and then honors its commitment to pay once it is satisfied that the terms and conditions of the letter of credit have been met; and (6) the issuing bank arranges for repayment from its customer, the buyer, in return for the documents that allow the buyer to take possession of the merchandise. In practice, the negotiating bank may pay the seller immediately after confirming that the documents comply and either debit the issuing bank's account immediately or await its repayment.

The documents that a letter of credit requires the seller to deliver vary but commonly include a transport document, such as an ocean or marine bill of lading, issued by the shipping company to the seller. The billing of lading serves as a receipt for the goods and also conveys title to them. Another is a draft or bill of exchange that is drawn by the seller on the buyer or buyer's bank, demanding payment of the amount specified in the letter of credit. Other documents that may be required in a letter-of-credit transaction include a commercial invoice, certificate of origin, packing list, inspection certificate, and insurance documents.

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