Letter of credit meaning: how an LC works, step by step, with an example

Letter of credit meaning in one paragraph

A letter of credit (LC) is a written promise from a bank. The bank promises to pay a seller, up to a stated amount, at sight or at a fixed later date, if the seller presents documents that comply with the credit's terms (International Chamber of Commerce). The buyer asks for it and pays for it. The seller relies on the bank, not on the buyer. This page shows how that promise moves, one step at a time. For the parties and the costs in more depth, see the letter of credit page.

The LC process in eight steps

The names below follow the ICC's rules for documentary credits, UCP 600 (International Chamber of Commerce, International Chamber of Commerce).

1. Sale contract. Buyer and seller agree on goods, price, shipping terms and payment by LC. The contract should say which documents the seller will present.
2. Application. The buyer (applicant) asks its bank to open the LC. The bank assesses the buyer like a borrower and sets the limit and margin. A bank generally issues an LC only for a customer that already has a funded facility with it, with exceptions such as full cash cover (RBI notification, see the letter of credit page).
3. Issue. The issuing bank issues the LC and sends it to a bank in the seller's country.
4. Advice, and confirmation if needed. The advising bank tells the seller the LC has arrived and checks it looks genuine. If the seller doubts the issuing bank or its country, it can ask a bank to confirm. A confirming bank adds its own promise to pay (International Chamber of Commerce).
5. Shipment. The seller reads every line of the LC, checks it can meet each condition, and ships the goods.
6. Presentation. The seller hands the required documents to the nominated bank or the confirming bank. These usually include an invoice and a transport document.
7. Examination. The bank checks the documents against the credit. Under UCP 600 a bank has a maximum of five banking days to accept or refuse them (International Chamber of Commerce).
8. Payment. If the presentation complies, the bank "honours" it. It pays at sight, or promises to pay at a later date, or accepts a draft and pays it at maturity (International Chamber of Commerce). The buyer then reimburses its bank and collects the documents to clear the goods.

What "complying presentation" means

The bank does not inspect the goods. It compares papers. The invoice, the transport document and any certificates must agree with the credit and with each other. A mismatch is called a discrepancy. The bank may refuse the documents or ask the buyer to accept them despite the mismatch.

Common causes of discrepancy:

• a description of goods that differs from the credit;
• a shipment or presentation date after the date the credit allows;
• an amount that exceeds the credit;
• a missing document that the credit lists;
• names or addresses that differ between papers.

Check each paper against the LC before you hand it to the bank.

Sight and usance in the process

In a sight LC, the bank pays when it finds the documents in order. In a usance LC, payment falls due at a later date set in the credit, so the buyer gets time to sell the goods. Under the second, the bank may accept a draft the seller has drawn on it and pay at maturity (International Chamber of Commerce). The types of letter of credit page covers more variants.

A worked example

This is an illustration, not a real transaction. The charges use one published bank card, so they are examples only.

A buyer in Pune orders goods worth ₹10,00,000 from a seller in Surat. The two agree on an inland usance LC for 120 days. The buyer is an unrated MSME, which Bank of Baroda's card prices as BBB (Bank of Baroda).

1. The buyer's bank opens the LC for ₹10,00,000.
2. The seller ships the goods and presents the invoice and transport document.
3. The bank finds the papers in order and accepts the draft.
4. After 120 days the bank pays the seller.

On that card, the commission for a usance LC at 1.50% a year for 120 days is about ₹4,932. Had the same LC run for 180 days, it would be about ₹7,397. A sight LC would be 0.70%, or ₹7,000, for its validity period. If the seller had asked a bank to confirm the LC, confirmation at 0.20% a month for four months would add ₹8,000 (Bank of Baroda). Each bank sets its own card, and the card shows an effective date of 10-Dec-2022.

Fees that arise along the way

Besides the commission for opening the LC, banks charge small fixed fees at certain steps. On Bank of Baroda's published card (effective 10-Dec-2022), an advising bank charged ₹1,000 to advise another bank's LC. Negotiation of documents was ₹1,000. A discrepancy charge was 0.15%, with a minimum of ₹500 and a maximum of ₹2,000 (Bank of Baroda). These are examples, and your bank's card will differ. Ask for the card before you agree to an LC, and ask which party in the sale contract bears each charge.

What if the bank pays and the buyer cannot reimburse?

The issuing bank has promised to pay, so it pays the seller. It then looks to the buyer. If the buyer cannot reimburse, the amount becomes a loan. RBI treats a devolved non-fund facility as a fund-based one from then on (RBI notification).

Standby letter of credit: a different flow

A standby LC is not drawn in the normal course. It pays only if the applicant fails to perform or pay. ICC calls it "a secondary obligation covering default only" (International Chamber of Commerce). The seller or beneficiary presents a demand and a statement of default instead of shipping documents. The bank guarantee page explains the matching idea.

A checklist before you ship

1. Read the LC against the sale contract, line by line.
2. List every document the LC asks for and who will issue each one.
3. Note the last shipment date and the last date for presentation.
4. Check the amount, the goods description and the names and addresses.
5. Ask your bank to request an amendment now, not after shipment, if any term is wrong.
6. Keep copies of every paper you present.

Mistakes that delay payment

1. Accepting an LC without reading it. Ask for an amendment before shipping if a term is wrong.
2. Shipping late, or presenting after the last date the credit allows.
3. Documents that disagree with each other.
4. Not planning for the bank's examination time, which UCP 600 caps at five banking days (International Chamber of Commerce).
5. Assuming an LC can be cancelled by the buyer. Under UCP 600, a credit is irrevocable by default (International Chamber of Commerce).

Next step

Capnix does not issue LCs. Banks do. If you need an LC limit, the bank will assess your business much as it would for a loan. The free loan readiness check shows how a lender is likely to read your file, with a Capnix score from 0 to 100.