Letter of Credit Mechanism

Letter of Credit (or Documentary Credit) is an undertaking issued by a bank for the account of the buyer or for its own account, to pay the seller against the value of the draft and/or other documents provided that the terms and conditions of the credit are complied with. LC is usually subject to the Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce Publication No. 600 (UCP 600).

Related Terms to understand L/C

1. ICC
The International Chamber of Commerce (ICC) is the largest and the most diverse business organization in the world with a global network of over 6 million members in more than 100 countries. The ICC aims to foster trade and commerce internationally and to promote and protect open markets for goods and services as well as for the free flow of capital. It performs three primary activities: establishment of rules, resolution of disputes, and policy advocacy.

2. UCPDC
The Uniform Customs and Practice for Documentary Credits (UCP) is a set of rules on the issuance and use of letters of credit. The UCP is utilized by bankers and commercial parties in more than 175 countries in trade finance. Historically, commercial parties, particularly banks, have developed the techniques and methods for handling letters of credit in international trade finance. This practice has been standardized by the ICC by publishing the UCP in 1933 and subsequently updating it throughout the years. The ICC has developed and molded the UCP by regular revisions, the current version being the UCP600.

3. SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides a network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardized, and reliable environment.

4. LIBOR
The London Interbank Offered Rate is the average of interest rates estimated by each of the leading banks in London that it would be charged were it to borrow from other banks. LIBOR is the world’s most widely-used benchmark for the short-term interest rates at which banks offer to lend funds to one another in the international interbank market.

5. Shipping Documents
Documents required clearing customs and taking delivery of the goods including commercial invoice, packing list, bill of lading or airway bill, certificate of origin, inspection certificate, bill of exchange etc.

6. Bill of Exchange or Draft
A draft also called a bill of exchange is a formal demand for payment. It is an unconditional promise drawn by one party, usually the exporter, instructing the importer to pay the face amount of the draft at sight or at a specified future date. 

7. Nostro vs Vostro Account

Nostro account and Vostro account refer to the same thing from a different perspectives. These accounts are used to facilitate international transactions. 

1. Nostro Account : Italian word 'nostro' means 'ours'. Nostro Account means “Our account with you”. The account that a domestic bank maintains with a foreign bank is known as nastro account. For example, Sonali Bank's account with Bank of America in USA.
2. Vostro Account : Italian word 'vostro' means 'yours'. Vostro Account means “your account with us”. The account that a foreign bank maintains with domestic bank is known as vostro account. For example, Bank of America's account with Sonali Bank in Bangladesh.

Parties in Letter of Credit Transaction

1. LC Applicant
LC Applicant is normally the buyer under the sales contract and the party that initiates the request to the Issuing Bank to issue an LC on its behalf. The LC Applicant normally maintains banking facilities with the Issuing Bank.

2. LC Beneficiary
LC Beneficiary is normally the seller under the sales contract and the party who will receive payment under the LC if it can fulfill all the terms and conditions of the credit.

3. Issuing Bank
An Issuing Bank (or LC opening bank) is the bank that issues the LC in favor of a seller at the request of the LC applicant. The Issuing Bank is normally located in the applicant’s country with an established banking relationship with the applicant. By issuing an LC, the Issuing Bank undertakes to pay the beneficiary the value of the draft and/or other documents if all the terms and conditions of the LC are complied with.

4. Advising Bank
An Advising Bank (or sometimes known as notifying bank) is the bank that advises the LC beneficiary that there is an LC issued in his favor. Advising Bank is normally located in the seller’s country and is either appointed by the Issuing Bank or LC applicant. Its primary responsibility is to authenticate the LC to ensure that the LC comes from genuine source.

5. Confirming Bank
A Confirming Bank (normally also the Advising Bank) is the bank that adds its own undertaking to pay the LC beneficiary if all terms and conditions of the credit are complied with. Such undertaking is in addition to that given by the Issuing Bank at the request of the Issuing Bank. The Confirming Bank will only confirm an LC upon satisfactory evaluation on the conditions of the Issuing Bank and its domicile country.

6. Nominated Bank
A Nominated Bank is a bank authorized by the Issuing bank in the credit to pay, negotiate, issue a deferred payment undertaking or accept drafts under the LC. If the LC does not specify a Nominated Bank, the LC is deemed as freely negotiable and any banks that receive documents from the LC beneficiary are qualified to be a Nominated Bank. A Nominated Bank is not responsible to pay under the credit unless it has added its confirmation to the credit. In such a case, it will become a Confirming Bank.

7. Negotiating Bank
A Negotiating Bank is the bank that examines the drafts and/or documents presented by the LC beneficiary and gives values to such drafts and/or documents. Negotiation could be in the form of purchasing or agreeing to purchase the drafts and/or documents presented.

8. Reimbursing Bank 

A Reimbursing Bank is the paying agent appointed by the Issuing Bank to honor claims submitted by the nominated or negotiating bank.

The Flow of Letter of Credit

Stage: 1 Letter of Credit Issuance and Advising/Confirmation

Step 1:

The buyer and seller conclude the sales contract and agreed to use LC as the method of payment.

Step 2:

The buyer approaches the Issuing Bank to issue an LC on his behalf in favor of the seller with all the terms and conditions specified.

Step 3:

Issuing Bank issues the LC and requests the advising bank to advise or confirm the credit to the LC beneficiary (seller).

Step 4:

Advising/confirming bank authenticates the LC and provides it to the beneficiary.

Stage: 2 Presentations of Documents and Settlement

Step 5:       

Seller prepares and dispatches the goods to the buyer’s country.

Step 6:       

Seller arranges the shipping documents and presents them to the nominated and or negotiating bank within the presentation period allowed under the letter of credit.

Step 7:

Negotiating and or nominated bank checks the presented documents against the terms and conditions of LC. If needed bank negotiates under complying presentation by advancing or agreeing to advance fund to the exporter on or before banking day on which payment is due to the negotiating and/or nominated bank.

Step 8:

Nominated and or negotiating bank forwards shipping documents to the Issuing Bank.

Step 9:

The issuing bank checks documents presented against the LC terms and conditions. If documents are free from discrepancies issuing bank pays to the negotiating bank within the period allowed under the letter of credit.

Step 10:

Issuing Bank presents documents to the buyer for payment.

Step 11:   

Once payment is received from the buyer, issuing bank releases documents to the buyer to collect the goods.