What is letter of credit and how does it work?
Letter of credit is a popular financial instrument used in facilitating international trade. Basically a letter of credit is a written instrument issued by a bank at the request of its customer. The letter of credit promises to pay the beneficiary of the seller or exporter the desired sum of money once the exporter presents all documents as mutually agreed in the terms and conditions of the letter of credit.
A letter of credit is, in essence, a promise made by a bank or a financial institution on behalf of a buyer/importer to pay the beneficiary/exporter a certain amount of money in an agreed upon currency.
Typically, after a sales contract has been negotiated and letter of credit has been agreed upon as the method of payment, the Applicant will contact a bank to ask for a letter of credit to be issued, and once the issuing bank has ascertained that the Applicant will be able to pay for the goods, it will issue the letter of credit. Once the Beneficiary receives the letter of credit, it will check the terms to ensure that it matches with the contract and will either arrange for shipment of the goods or ask for an amendment to the letter of credit so that it meets with the terms of the contract. The letter of credit is limited in terms of time, the validity of credit, the last date of shipment, and in terms of how much late after shipment the documents may be presented to the Nominated Bank.
Once the goods have been shipped, the Beneficiary will present the set of requested documents to the Nominated Bank. This bank will check the documents, and if they comply with the terms of the Letter of Credit, the issuing Bank is bound to honor the terms of the letter of credit by paying the Beneficiary.