What is a Letter of Credit?
A letter of credit is a banking mechanism which allows importers
to offer secure terms to exporters.
All letters of credit contain these elements:
A payment undertaking given by a bank (Issuing bank) on behalf of a buyer (applicant):
- to pay a seller (beneficiary) a given amount of money
- on presentation of specified documents representing the supply of goods
- within specific time limit
- these documents conforming to terms and conditions set out in the letter of credit
- documents to be presented at a specified place
Essentially , the Issuing bank has two main roles:
- to give a binding undertaking to the seller that if compliant documents are presented, the bank will pay the seller the amount due. This offers security to the seller - the bank says in effect "We will pay you if you present the required documents
- to examine the documents, and only pay if these comply with the terms and conditions set out in the letter of credit. This protects the buyer's interests - the bank says We will only pay your supplier on your behalf if they present documents (XYZ) that you have asked for
The letter of credit refers to documents representing the goods - not the goods themselves! Banks are not in the business of examining goods on behalf of their customers.
Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document,but there are many others.
Letters of credit deal in documents, not goods.