Letter of credit (L/c) is the most preferred
payment option for exporters. Compared to other payment
options, L/c has many safeguards for sellers and at
the same time assurance for buyers. It is usually
issued by larger banks and contain a promise to pay
a seller (beneficiary) upon receipt of goods by a
buyer if certain conditions outlined in the letter
have been met.
What is Letter of Credit ?
Letter of Credit or (L/c) is a legal document to
arrange payment between a buyer(importer) and seller
(exporter). The bank, as intermediary, ensures security
for both parties, giving the exporter confidence that
the importer is capable of paying for the goods while
assuring the importer that payment will be made to
the exporter only after the terms outlined in the
letter of credit have been met.
Analysis of typical L/c Transaction
Though a L/c can have great many variations (please
see later part of this article) - for simplicity and
ease of understanding, I have made a simple step-by-step
description of a typical L/c transaction.
- Step 1 After successful negotiation
on price, specification, quality etc, Buyer selects
a seller and places order for specified goods
- Step 2 Seller accepts the order
- Step 3 Buyer and Seller agrees
on terms and conditions of the sale. Buyer instructs
its bank to open a L/c incorporating previously
agreed terms of sale
- Step 4 The buyer's bank prepares
a Letter of Credit (L/c), including all instructions
to the seller's bank concerning the shipment and
sends the L/c to the seller's bank, requesting confirmation.
The seller may request confirmation from a confirming
bank for added security.
Note: There are often delays
at above two steps for various reasons like buyer
does not have sufficient funds or seller requests
change in L/c terms. Amendments are issued to incorporate
changes in L/c terms.
- Step 5 The Seller's bank prepares
a letter of confirmation to forward to the seller
along with the L/c. The seller reviews carefully
all conditions in the L/c specially shipment schedule
in consultation with his freight forwarder.
- Step 6 The seller arranges the
goods and hand over to freight forwarder for delivery
at appropriate port or airport.
- Step 7 Once goods are loaded/shipped,
the forwarder completes necessary documentation
and hand them over to the seller. The seller then
presents the documents to his bank, informing full
compliance with terms and conditions of L/c.
- Step 8 The seller's bank reviews
the documents. If they are in order, the documents
are airmailed to the buyer's bank for review and
passing necessary documents to buyer. The buyer
gets the documents needed to claim the goods.
- Step 9 The buyer's bank returns
accepted draft and informs buyer. Buyer pays bank.
- Step 10 The seller's bank gets
payment and pays seller.
The letter of Credit Ensures that:
Payment to the seller will only be made after the
terms of the L/c have been met. The documents, which
have been reviewed by the bank's experienced staff,
are in order. The seller is assured of the buyer's
ability to pay and, as a result, a better price and
more advantageous terms of payment may be offered.
Is Letter of Credit 100% Safe for
Exporters ?
The answer is - yes and no. Yes, if you follow all
L/c instructions. No, if you overlook certain pitfalls.
For detail discussion on potential pitfalls in L/c
payment and how to secure your position as seller
- please read following article published in past
issue of FAIDA
Letter of Credit - How to secure your payment
Be aware of potential traps in L/c payment
FAIDA Vol II, Issue 7; July 11' 2001
(please see Related Links below)
Various Kinds of L/c and its Lingo
For information on various kinds of L/c and meaning/implication
of technical terms - please read following article
published in past issue of FAIDA
More on Letter of Credit - Closer look at some key
terminology
FAIDA Vol II, Issue 8; July 18' 2001
(please see Related Links below)
