A Letter of Credit is a negotiable instrument, where the issuing bank pays the beneficiary (exporter) or any bank nominated by the beneficiary. First, it is important for the importer to prove to the respective bank that he/she has enough assets to make the required payment, before the bank guarantees the payment to the exporter. The bank takes the entire responsibility that the exporter will be paid. The bank usually charges a fee, as a sign of premium, after sending a Letter of Credit. In case the Letter of Credit is transferable, the beneficiary (exporter) can assign another business, such as a corporate parent or a third party, the right to draw2.
Here’s a detailed step-by-step process:
1. Issuance of Letter of Credit
After the parties involved in the trade activity agree to the contract and use of a Letter of Credit, the importer applies to the issuing bank for a Letter of Credit in favour of the exporter. LC is then sent by the issuing bank to the advising bank. The advising bank (of the exporter) verifies the authenticity of the Letter of Credit and forwards it to the exporter.
3. Providing documents to the confirming bank
After the goods are shipped, the exporter presents the documents to the advising/confirming bank.
4. Settlement of payment from importer and possession of goods
The bank sends the documents to the issuing bank. The amount is paid, accepted or negotiated. The issuing bank verifies every document and then obtains payment from the importer. The documents are then sent to the importer, who uses it in order to get possession of the shipped goods.