Meaning of Letter of Credit
A Letter of Credit is a written undertaking issued by a bank on behalf of an importer (applicant), promising to make payment to an exporter (beneficiary) provided that the exporter presents documents strictly complying with the terms and conditions specified in the credit.
In simple terms, an LC is a bank’s conditional guarantee of payment.
Importance of Letter of Credit in International Trade
Letter of Credit plays a crucial role in international trade by:
- Reducing payment risk for exporters
- Providing assurance of shipment compliance for importers
- Facilitating financing from banks
- Ensuring documentary control rather than physical goods control
LCs act as a bridge of trust between buyers and sellers who may have no prior business relationship.
Parties Involved in a Letter of Credit
Applicant
The applicant is the buyer or importer who requests the issuing bank to open a Letter of Credit in favor of the exporter.
Issuing Bank
The issuing bank is the importer’s bank that issues the Letter of Credit and undertakes to honor payment upon receipt of complying documents.
Beneficiary
The beneficiary is the seller or exporter in whose favor the LC is issued and who is entitled to receive payment under the credit.
Advising Bank
The advising bank, usually located in the exporter’s country, advises the LC to the beneficiary after verifying its authenticity.
Confirming Bank
The confirming bank adds its own payment guarantee to the LC upon the request of the issuing bank, giving additional security to the exporter.
Negotiating Bank
The negotiating bank examines the documents and may purchase or negotiate the export documents if they comply with LC terms.
Reimbursing Bank
The reimbursing bank authorizes reimbursement to the negotiating bank on behalf of the issuing bank.
Types of Letter of Credit
Revocable Letter of Credit
A revocable LC can be amended or canceled by the issuing bank without prior notice to the beneficiary. Due to insecurity, it is rarely used in modern trade.
Irrevocable Letter of Credit
An irrevocable LC cannot be amended or canceled without the consent of all parties. It offers greater security and is the most commonly used form of LC.
Confirmed Letter of Credit
A confirmed LC includes an additional payment guarantee from the confirming bank, reducing country and bank risk for the exporter.
Unconfirmed Letter of Credit
An unconfirmed LC carries only the issuing bank’s obligation without confirmation from another bank.
Sight Letter of Credit
Payment is made immediately upon presentation of complying documents.
Usance or Deferred Payment Letter of Credit
Payment is made after a specified period, such as 30, 60 or 90 days after shipment or acceptance.
Back‑to‑Back Letter of Credit
Issued on the basis of a master LC, commonly used by intermediary traders or buying houses.
Transferable Letter of Credit
Allows the beneficiary to transfer the credit, wholly or partially, to one or more second beneficiaries.
Key Components of a Letter of Credit
Amount and Currency
The LC specifies the amount payable and the currency in which payment will be made.
Description of Goods
Goods must be described clearly and consistently with the sales contract.
Shipment Terms
Includes shipment date, port of loading, port of discharge, mode of transport and partial shipment conditions.
Required Documents
Typical documents include:
- Commercial Invoice
- Bill of Lading or Air Waybill
- Insurance Certificate
- Certificate of Origin
- Inspection Certificate
Validity and Expiry
The LC specifies expiry date and place for presentation of documents.
Process of Letter of Credit Operation
Opening of Letter of Credit
The importer applies to the issuing bank to open an LC by submitting:
- LC application form
- Sales contract or proforma invoice
- Margin and required securities
Advising of Letter of Credit
The issuing bank transmits the LC to the advising bank, which then advises it to the beneficiary after authentication.
Shipment of Goods
After receiving and checking the LC, the exporter ships the goods according to LC terms.
Presentation of Documents
The exporter submits documents to the negotiating or advising bank within the stipulated time.
Examination of Documents
Banks examine documents strictly on the basis of:
- LC terms
- UCP 600
- International Standard Banking Practice (ISBP)
Payment or Acceptance
If documents comply:
- Payment is made at sight or
- Acceptance is given for future payment
Reimbursement and Settlement
The negotiating bank is reimbursed by the issuing or reimbursing bank and the importer receives documents for goods clearance.
UCP 600 and Letter of Credit
Uniform Customs and Practice for Documentary Credits
UCP 600, issued by the International Chamber of Commerce (ICC), governs the operation of Letters of Credit worldwide. It defines:
- Roles and responsibilities of banks
- Standard interpretation of LC terms
- Rules for examination of documents
Principle of Documentary Compliance
Banks deal with documents, not goods. Even if goods are defective, payment cannot be refused if documents comply.
Discrepancies in Letter of Credit Documents
Common Causes of Discrepancies
Typical discrepancies include:
- Late shipment
- Late presentation
- Description mismatch
- Incorrect documents
- Unauthorized issuance
Consequences of Discrepancies
Discrepant documents may result in:
- Payment refusal
- Delayed settlement
- Additional charges
- Loss of exporter credibility
Advantages of Letter of Credit
Benefits for Exporters
- Assured payment
- Reduced credit risk
- Access to bank financing
- International credibility
Benefits for Importers
- Control over shipment terms
- Assurance of document compliance
- Improved supplier confidence
Limitations of Letter of Credit
Despite its advantages, LC has some limitations:
- Costly bank charges
- Rigid compliance requirements
- Time‑consuming documentation
- No guarantee of goods quality
Role of LC in Modern Trade Finance
Letter of Credit remains a cornerstone of global trade finance, particularly in:
- High‑value transactions
- New trade relationships
- Country‑risk environments
- Regulated foreign exchange economies
Importance of Proper LC Understanding
A thorough understanding of Letter of Credit is essential for:
- Exporters and importers
- Bankers and trade officers
- Auditors and compliance professionals
Proper LC management minimizes disputes and ensures smooth international trade operations.
Procedure for Import Through Letter of Credit (LC)
This procedure outlines the complete operational steps involved in importing goods through a Letter of Credit (LC), covering application, issuance, shipment, document handling, payment, retirement and post‑import compliance under standard banking practice.
Step 1: Sales Contract and Requirement of LC
The import process begins when the importer and the foreign supplier enter into a sales contract or issue a proforma invoice stating the price, quantity, quality, delivery terms, shipment schedule and payment method. When payment is agreed to be made through a Letter of Credit, the importer proceeds to request issuance of the LC from their bank.
Step 2: Application for Opening Letter of Credit
The importer submits an application to the issuing bank along with the LC application form, proforma invoice or sales contract, required cash margin and any other security or documents as required by the bank. The issuing bank evaluates the importer’s creditworthiness and compliance with foreign exchange regulations.
Step 3: Issuance of Letter of Credit
After approval, the issuing bank opens the Letter of Credit strictly in accordance with the applicant’s instructions, prevailing banking rules and foreign exchange regulations. The LC is transmitted electronically, usually via SWIFT, to the advising bank located in the exporter’s country.
Step 4: Advising of Letter of Credit
The advising bank verifies the authenticity of the LC and advises it to the exporter. The advising bank does not assume any payment responsibility unless it adds confirmation. The exporter carefully examines all terms and conditions of the LC.
Step 5: Shipment of Goods
Upon confirming that the LC terms are acceptable, the exporter manufactures or procures the goods and ships them within the validity period and shipment terms stated in the LC. Any deviation from LC terms may lead to discrepancies.
Step 6: Preparation and Presentation of Documents
After shipment, the exporter prepares the required export documents, which generally include the commercial invoice, bill of exchange, bill of lading or air waybill, insurance certificate, certificate of origin and any other documents stipulated in the LC. These documents are then submitted to the negotiating bank.
Step 7: Scrutiny and Negotiation of Documents
The negotiating bank examines the submitted documents strictly in accordance with the LC terms and standard banking practice.
- If documents are compliant, the bank negotiates the documents or forwards them to the issuing bank for payment.
- If documents are discrepant, they may be corrected, sent for acceptance on collection basis, sent after obtaining waiver from the issuing bank or paid under indemnity where permitted.
Step 8: Receipt of Import Bills by Issuing Bank
Upon receipt of documents, the issuing bank records them in the inward register and keeps them in safe custody. The bank scrutinizes the documents independently to verify compliance with LC terms. Any discrepancies are communicated to the importer for acceptance or rejection.
Step 9: Lodgment of Import Documents
If documents are found in order or accepted by the importer, the issuing bank lodges the import bills by making payment to the negotiating bank. The LC liability is adjusted, foreign currency is converted at the applicable selling rate and the amount is transferred to the Payment Against Documents (PAD) account. Relevant IMP forms and LCAF are endorsed.
Step 10: Intimation to Importer
Immediately after lodgment, the issuing bank sends an intimation letter to the importer specifying the bill amount, applicable interest and bank charges and requests prompt retirement of the documents.
Step 11: Retirement of Import Documents
The importer retires the import documents by paying the full bill value along with interest and charges. After settlement, the bank releases the shipping documents to the importer to enable customs clearance of the goods.
Step 12: Submission of Bill of Entry
After clearing the goods from customs, the importer must submit an authenticated copy of the customs Bill of Entry to the issuing bank within the prescribed time period.
Step 13: Matching and Closure of Import Transaction
The issuing bank verifies the Bill of Entry with the IMP form, invoice and LC details.
- If everything is found in order, the import transaction is treated as closed.
- If the Bill of Entry is not submitted or material discrepancies are found, the case is reported to the regulatory authority for necessary action.
End of Procedure
This completes the import procedure through Letter of Credit, ensuring proper control of foreign exchange, banking compliance and transparent international trade operations.
