A Letter of Credit (LC) is a crucial instrument in trade finance, ensuring secure and timely payment for goods and services. Here’s a comprehensive step-by-step guide on how an LC is issued and used in international trade:
Step 1: Trade Agreement Between Buyer and Seller
- Negotiation: The buyer (importer) and seller (exporter) agree on the terms of the transaction, including price, delivery, and payment.
- Inclusion of LC Clause: The contract specifies that payment will be facilitated through an LC.
Step 2: Buyer Requests LC Issuance
- Buyer’s Bank Application: The buyer approaches their bank (issuing bank) to request an LC in favor of the seller.
- Submission of Details: The buyer provides key information, such as:
- Seller’s name and bank details.
- Description of goods/services.
- Amount and currency.
- Required documents (e.g., bill of lading, invoice).
- LC type (e.g., sight, usance, red clause).
Step 3: Issuance of the LC
- Bank’s Risk Assessment: The issuing bank evaluates the buyer’s creditworthiness before issuing the LC.
- LC Transmission: The LC is sent to the seller’s bank (advising bank) via the SWIFT network, typically using an MT 700 message.
Step 4: Advising Bank Notifies the Seller
- Verification of LC: The advising bank verifies the authenticity of the LC.
- Notification: The seller is informed that the LC has been issued in their favor.
Step 5: Seller Ships the Goods
- Shipment of Goods: The seller arranges for the shipment of goods as per the LC terms.
- Preparation of Documents: The seller gathers the required trade documents, such as:
- Commercial invoice.
- Packing list.
- Bill of lading.
- Certificate of origin.
- Inspection certificate.
- Insurance certificate.
Step 6: Submission of Documents to the Advising Bank
- Document Presentation: The seller submits the documents to the advising bank to prove compliance with the LC terms.
- Initial Verification: The advising bank checks the documents for any discrepancies.
Step 7: Document Forwarding to Issuing Bank
- Transmission of Documents: The advising bank forwards the verified documents to the issuing bank for final review.
- SWIFT Message: The bank may use an MT 730 message to acknowledge receipt of the documents.
Step 8: Issuing Bank Verifies Documents
- Compliance Check: The issuing bank carefully examines the documents against the LC terms.
- Approval or Discrepancy Notification: If the documents are compliant, payment is processed. If discrepancies are found, the bank notifies the seller.
Step 9: Payment to the Seller
- Payment Execution:
- For Sight LC: Payment is made immediately upon document approval.
- For Usance LC: Payment is made after the deferred period (e.g., 30, 60, or 90 days).
- Credit to Seller’s Account: The advising bank credits the payment to the seller’s account.
Step 10: Issuing Bank Reimbursed by Buyer
- Buyer’s Settlement: The buyer reimburses the issuing bank as per the agreed terms.
- Document Release: Once payment is made, the issuing bank releases the shipping documents to the buyer, enabling them to claim the goods.
Step 11: Buyer Takes Delivery of Goods
- Customs Clearance: The buyer uses the shipping documents to clear the goods from customs.
- Receipt of Goods: The transaction is completed with the buyer taking possession of the goods.
Key Players in the LC Process
- Applicant (Buyer): Requests the LC and is ultimately responsible for payment.
- Beneficiary (Seller): Receives payment upon meeting LC conditions.
- Issuing Bank: Issues the LC on behalf of the buyer.
- Advising Bank: Verifies and forwards the LC to the seller.
- Confirming Bank (if applicable): Adds its guarantee of payment.
- Carrier/Shipping Company: Provides transport documents like the bill of lading.
Benefits of This Process
- For Sellers:
- Ensures secure and timely payment.
- Protects against buyer default.
- For Buyers:
- Guarantees goods are shipped as per the agreement.
- Provides access to financing for large transactions.
The Letter of Credit process ensures secure, transparent, and efficient trade transactions. By involving trusted financial intermediaries, LCs minimize risks and foster confidence between buyers and sellers in global trade.
Pingback: What Are the Documents Required for a Letter of Credit? – Trade Financer