How Does a Letter of Credit (L/C) Work

Exporting and Importing can often be an extremely complicated and mundane process as there are so many rules, regulations as well as countless  number of procedures to adhere to. This, many a times, may require to prepare and submit documents for import and export. Usually, freight forwarders would prepare it  for us, but it is also good to know for ourselves as to how to complete the relevant documents by understanding what the terms mean. As such, in our new article series titled “Export Terms”, we would  introduce you to all the various terms used in the international trade, be it through air, land or sea freight. We would roll out one related article on a regular basis, which would help you to get a comprehensive understanding as to the document preparation for the purpose of doing trade internationally. In today’s article, we would cover the details of the Letter of Credit

What is a Letter of Credit?

A Letter of Credit is also known as an L/C. An L/C  is essentially a written commitment to pay the amount due, by the importer to the exporter. The importer’s bank is known as the issuing bank in this case, while the exporter’s bank is known as the accepting or the negotiating bank. As such, in business transactions where a Letter of Credit is Involved, there are usually four parties.

By  issuing the L/C to the exporter, it is as equal as guaranteeing the exporter that the importer would  make the payment to him in a sum and currency that is specified in the L/C. However, this can only take effect if the exporter fulfills all of his required duties.

An L/C is a formal document that is usually used when the seller is unwilling to extend credit to the buyer. As such, the L/C substitutes the creditworthiness of the bank for that of the importer. The Letter of Credit Document is also a non negotiable document. This is unlike other documents such as the Bill of Exchange (B/E).

Letter of Credit exists in the form of Revocable Letter of Credit as well as Irrevocable letter of credit

Revocable Letter of Credit

In essence, the revocable Letter of Credit can be modified or cancelled by the bank at any time. This is done without the approval of the seller. However, revocable L/Cs are not commonly used.

Irrevocable Letter of Credit

The irrevocable L/C on the other hand cannot be modified or cancelled unless all the parties  which are involved in the transaction agree to do so. The Exporter also needs to approve of the modifications first.

The process of L/C

The Process of a transaction involving the L/C is as follows:

  1. Importer and Exporter enter into a contract

2. Importer applies for an L/C with the Issuing Bank.

3. Issuing Bank sends the L/C to the Advising Bank which goes to the exporter as a result.

4. Exporter then sends  the goods to the importer.

5. Exporter submits all relevant documents to the Advising bank which upon reaching the importer, the importer makes the payment through the banks.

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One Reply to “How Does a Letter of Credit (L/C) Work”

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