What is Letter of Credit (LC) ? Parties involved, Process

Trade between different countries of the world to exchange goods and services among themselves is called international trade (read what is International trade). There are innumerable risks associated to an international trade which create hindrances to the trade. That is exactly when a risk minimising option called Letter of Credit or LC offered by banks and financial institutions comes to the rescue of both the sides of a trade. (Read types of letter of credit)

Let us see what a Letter of Credit means, who are the parties, involved in LC and how the LC process takes place in simple words using an example.

Letter of Credit : Definition

Letter of Credit is a piece of paper issued by the bank of the importer on the request of the importer by which it agrees to pay the exporter the amount of money to be paid in exchange for the delivery of the goods if the importer fails to pay only after all the goods delivered on time and are as per the order. So, the entire risk of payment is borne by the bank of the importer. (Read What Is Bank Guarantee (BG) With Example )

Illustration of Letter of Credit

Let us assume that there is an international trade contract between Mr. A from the U.S.A. being the importer and Mr. X being the exporter from Singapore. Now, there is ABC bank of the U.S.A., called the issuing bank, which is the bank connected with Mr. A and XYZ Bank of Singapore, called the advising bank which is the bank connected with Mr. X. The advising and the issuing banks charge a certain amount of fees and commission for the services they provide.

Parties involved in Letter of Credit

So in a simple LC scenario there are 4 parties involved.

1. Mr. A – the importer from USA
2. ABC Bank - the issuing bank (bank which supports the importer)
3. Mr. X – the exporter from Singapore
4. XYZ Bank – the advising bank (bank connected with the exporter)

Steps in a Letter of Credit

In all, a letter of credit has 8 steps from the time the transaction originates to when both the sides are compensated.

1. Mr. A places an order with Mr. X and is expected to submit a Letter of Credit to Mr. X.
2. So, he goes to ABC bank and submits an application requesting a Letter of Credit in favour of Mr. X.
3. Once the issuing bank, ABC Bank satisfies itself with the credentials of Mr. A, it issues an LC which it passes on to XYZ Bank, the advising bank.
4. After XYZ bank checks the authenticity of the LC issued by ABC bank and makes all other relevant checks, approves it and informs Mr. X that an LC is issued in his favour.

   

   Procedure of Letter of credit

5. Then Mr. X prepares all the necessary documents related to the contract submits his bank for approval and simultaneously releases his goods for delivery to Mr. A.
6. These submitted documents are verified by XYZ bank which after approving them sends it to the ABC Bank.
7. After the issuing bank, ABC Bank checks and approves the documents sent by the advising bank, it releases the documents to Mr. A and also charges commission and fees from him, who can now take the delivery of his order against these documents.
8. ABC bank now releases the payment to XYZ bank who then credits to the Mr. X’s account after charging some commission for the services provided.

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