Letter of Credit Mechanism / Process: Definition, Working Mechanism, And Mores

Introduction

Million-dollar international trading is performed every day between different countries all around the globe.

The security of the payment process and the monetary transaction is the main concern in any foreign and domestic deals.

Many payment mechanisms have been introduced by economists and accountants but the letter of credit process is gaining popularity in the trading industry since the 19th century.

To increase the professionalism of the trading, the letter of credit process is considered one of the most efficient and safe payment instruments in which a bank agrees to become a guarantor between the sellers and buyers.

Let’s see the deeper meaning of letter of credit (LC) and how this trading’s payment & goods exchange take place step by step.

Definition

A letter of credit is a financial documentation that provides the facility of payment warranty by the bank.

The underwriting letter is presented by the importer’s bank to the exporting party that goods or services would be dispatched to the importer as stated in the terms & conditions. The following parties are part of this legal obligation;

  • Applicant: Someone who applies for the letter of credit. In most cases, it is an importer/buyer.
  • Beneficiary: The party for whom the LC document is issued. This usually the exporter/seller.
  • Issuing Bank: The bank that issues the LC at the request of the applicant. The bank is located in the importer’s hometown.
  • Advising Bank: The bank advises the exporters throughout this letter of credit procedure.

In the cross border transaction, the bank becomes bridged and make sure that both importing & exporting parties fulfill their committed obligations. 

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International contractual agreement through LC builds confidence and trust in performing the business activities where there are hurdles like different laws & policies and distance from the home country, etc.

Revocable, Irrevocable, Red Clause, Green Clause, Standby, Back-To-Back, Confirmed, Unconfirmed, Revolving, Sight, Usance, and Transferable are the types of letter of credit.

This process provides transparency in agreed terms, assurance of payment, security regarding the clearance of transportation procedure, and delivery time.

Working Mechanism of Letter of Credit

Let’s consider a buyer from England who wants to buy machinery of $15000 from a seller in the US by documentary letter of credit.

The importer and exporter both agree on the terms of trading then the order of events may be as follows;

  1. The importer requests the bank to issue a letter of credit in the name of the exporter.
  2. The document of LC includes all important aspects of the agreement such as invoice, pancaking list, bill of exchange, bill of lading, insurance in case of damage or loss, inspection security of origin, duty wavier certification, the number of goods, and delivery schedule, etc. 
  3. The seller delivers the machinery to the importer’s location and prepares the documentation according to LC requirements.
  4. The seller advising the bank to check the documents for the mistakes. If no discrepancies are found the papers are sent to the issuing bank.
  5. The importer’s bank checks the document and after satisfaction makes a complete payment of $15000 to the issuing bank and submits issuing bank charges.
  6. The buyer takes the final documents and clears the machinery from the shipping line location.
  7. The buyer’s bank transfers the $15000 to the seller’s advising bank.
  8. Advising bank takes away its service fee and handover reaming payment to the seller.
  9.  On the completion of the whole process, the beneficiary obtains its payment.
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Significance of Letter of Credit Mechanism

The banks play a vital role in business agreements from beginning to end. With a letter of credit, the merchants get the security of payment and delivery of goods. It minimizes the risk factor and fraud. 

The contract is high customizable the agreement is done with mutual consent. It gives the opportunity to safely expand business at a worldwide level.

It is more beneficial for the importer because as a credit certificate for the buyer. The best thing about LC is the payment is assured indisputable circumstances as well. 

How Much Cost Is Incurred In Letter Of Credit Mechanism?

The buyer is required to submit the contractual payment to the seller and the issuing bank also charges the fees and interest from the applicant.

Contrastingly, the seller is also obligated to pay fees to the advising bank.

Conclusion

A letter of credit mechanism or process is a well-organized payment instrument.  The seller and buyers agree on the terms of contact for the shipment of goods and payment of services. Both trading partners must fulfill legal bindings.

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