Letter of Credit Basics: L/C Transaction

How does a letter of credit work? How to use a letter of credit in import and export businesses?

So far, I have published two articles under "Letter of Credit Basics" series at advancedontrade.com

First article was published with the following title: "Letter of Credit Basics: Definition and Types". Second article's title was "Letter of Credit Basics: Parties to Letters of Credit".

This is the 3rd article of "Letter of Credit Basics" series and it will be focused on letter of credit transaction process.

With the help of an illustration and detailed explanations, letter of credit transaction will be covered from beginning to end.

How does a letter of credit work?

After reading this article, you should be able to answer questions such as:
  • Who is initiating the letter of credit issuance process? Importer or exporter?
  • Which party advices the credit to the exporter?
  • Which party / parties must pay letter of credit amount to the beneficiary against a complying presentation?



How does a letter of credit work?

How to use a letter of credit in import and export businesses?
Basic commercial letter of credit process
Step 1. Sales Contract: The importer and exporter start negotiating the terms and conditions of the deal. Once they reached an agreement, they sign a sales contract. (in some cases proforma invoice is used instead of a sales contract)

Step 2. Letter of Credit Application: After exporter and importer sign the sales contract, importer, who is defined as applicant under letter of credit rules, applies to its bank to issue a letter of credit.

The letter of credit application must be in accordance with the terms of the sales agreement.

Step 3. Letter of Credit Issuance:  Importer’s bank evaluates the letter of credit application. If importer’s bank and importer could reach an agreement, importer’s bank issues the letter of credit.

Today, majority of the letters of credit are issued in swift format.

Issuing bank sends the letter of credit to the advising bank via secure swift platform by online means. The message type is MT 700 Issue of a Documentary Credit.

Step 4. Advising Letter of Credit to The Beneficiary:  Letter of credit advised to the beneficiary by the advising bank.

According to letter of credit rules, the advising bank has two main responsibilities against the beneficiary.
  • Advising bank must satisfy itself as to the apparent authenticity of the credit
  • Advising bank must make sure that the advice accurately reflects the terms and conditions of the credit received.
Advising bank has no payment responsibility.

Step 5. Shipment:   Beneficiary prepares the goods and makes the shipment, if terms and conditions of the letter of credit workable for him.

Goods must be shipped before the latest date of shipment indicated in the letter of credit.

Step 6. Presenting Documents to Advising Bank:  In most cases, advising bank is also the nominated bank.

Less frequently, issuing banks restrict letters of credit, which are available with themselves only.

If the advising bank is also the nominated bank, the bank can accept the presentation and forward the documents to the issuing bank.

But keep in mind that according to UCP 600, receipt, examination and forwarding of documents by a nominated bank that is not a confirming bank does not make that nominated bank liable to honour or negotiate, nor does it constitute honour or negotiation.

If advising bank has no other title and merely acting as an advising bank, then the bank can only forward the documents to the issuing bank on behalf of the beneficiary.

Step 7. Forwarding Documents to the Issuing Bank: The advising bank forwards the documents to the issuing bank on behalf of the beneficiary.

Step 8. Checking Documents, Payment at Maturity:  At the final stage of the letter of credit process, issuing bank checks the documents according to the terms and conditions of the credit and governing letter of credit rules.

If documents are complying, issuing bank must pay the L/C amount to the beneficiary at maturity.

Issuing bank should release the complying documents to the applicant, after securing its payment, letter of credit amount plus commissions.
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