What is a Letter of Credit?

A Letter of Credit (L/C) refers to a written document issued by a bank (the issuing bank) at the request and instruction of an applicant or on its own initiative. Under the terms and conditions of the L/C, the bank promises to make payment to a third party (the beneficiary) or their designated party against the presentation of specified documents. In other words, an L/C is a conditional written payment guarantee issued by a bank.

In international trade, buyers and sellers may distrust each other. The buyer may worry that the seller will not ship the goods as agreed after receiving an advance payment, while the seller may fear that the buyer will not pay after the goods are shipped or shipping documents are submitted. Therefore, banks act as guarantors for both parties, handling the collection and delivery of documents on their behalf, replacing commercial credit with bank credit. The instrument used by banks in this process is the Letter of Credit.

Characteristics of a Letter of Credit:

1. An L/C is a self-sufficient document: It is independent of the underlying sales contract. When examining documents, banks focus on the written authentication of the L/C, separate from the actual trade transaction.

2. An L/C is a pure documentary transaction: Payment is made against documents, not goods. As long as the documents comply, the issuing bank must pay unconditionally.

3. The issuing bank bears primary liability for payment: An L/C represents bank credit and serves as a guarantee document. The issuing bank holds the primary responsibility for payment.

L/C Payment Process:

1. The import and export parties must explicitly agree in the sales contract to use an L/C for payment.

2. The importer applies to their local bank to issue an L/C by submitting an application form and paying a deposit or providing other guarantees, requesting the issuing bank to open an L/C in favor of the exporter.

3. The issuing bank opens an L/C naming the exporter as the beneficiary, based on the application, and notifies the exporter through its correspondent or agent bank (collectively called the advising bank) in the exporter’s location.

4. After shipping the goods and obtaining the required shipping documents, the exporter presents the documents to their local bank (which may be the advising bank or another bank) to negotiate payment as per the L/C terms.

5. The negotiating bank endorses the L/C on the reverse side, indicating the amount negotiated.