What do you mean by Letter of Credit (LC) & How Does It Work?

A Letter of Credit (LC) is a financial document which is issued by a bank for getting guarantees to a seller who will receive payment from a buyer, providing the specific conditions are met. It is generally used in international trade to decrease the risks associated with international transactions.

How does an LC Work in International Transaction?

1. Agreement Between Buyer & Seller

• The buyer and seller agree on the terms of the trade, including the payment method via LC.

2. Buyer Requests LC from Their Bank

• The buyer or importer goes to their bank (Issuing Bank) to issue an LC in favor of the seller (exporter).
• The LC outlines the required shipping documents and conditions for payment.

3. Issuing Bank Sent LC to the Seller’s Bank

• The buyer’s bank/issuing bank sends the LC to the seller’s bank e.i Advising Bank.
• The supplier’s/seller’s bank verifies the Letter of Credit’s authenticity and to inform the seller.

4. Seller Ships Goods

• The seller ships the goods as per the agreement and prepares the required shipping documents like Bill of Lading, Invoice, Packing List, etc.

5. Seller Submits All Documents to Their Bank

• The seller/supplier submits all the required documents to their Negotiating or Confirming Bank.
• The bank checks & verifies all the documents and sends them to the buyer’s bank.

6. The Issuing Bank or Buyer’s Bank Reviews & Makes Payment

• The issuing bank or buyer’s bank cross checks the documents provided by the seller’s bank with the LC terms.
• If all terms & conditions are correct, then the bank makes payment to the seller according to the LC terms.
• The buyer or importer receives the shipping documents to release the goods.

6 Types of Letter of Credit

1. Revocable LC – It can be changed anytime or canceled anytime without the seller’s consent.
2. Irrevocable LC – It never changes anytime without discussion from all parties.
3. Sight LC – The payment is made immediately when the documents are submitted and verification.
4. Usance (Deferred) LC – The payment is made after a specific time period mentioned in LC agreements..
5. Confirmed LC – The second bank guarantees the future payment in addition to the issuing bank.
6. Back-to-Back LC – It is used when an intermediary is involved in a trade.

Benefits of an LC

✅ Ensures the secure payments for the sellers.
✅ Reduces the transactional risks for buyers.
✅ Builds trustworthiness between the  international trade partners.
✅ Protects from fraudulent and non-payment condition.