MECHANISM IN LETTER OF CREDIT

While dealing by an individual or entity in different countries, both seller and

buyer do not have confidence on each other. Buyer would insist delivery of
goods first and would like to pay after receipt of goods. But Seller on the other
side would like to act on the contrary; he would like to receive funds first and
then would like to send the goods.

So in this situation there would not be any trade.

Since bank enjoys a repute of trust and confidence, so it acts as guarantor to both
seller and buyer.

It provides guarantee to seller that in case the goods are shipped to the buyer, he
would definitely get the value of goods. Similarly the buyer would be
guaranteed that he would get the goods according to the worth of his money.

This bridge of confidence is built by at least two bankers, i.e. banker of seller
and banker of buyer, and this trust are managed by way of an instrument known
as “Letter Of Credit”. And no doubt for providing such facility, both bankers
earn by way of charges those are either borne by buyer, seller or both of them as
agreed mutually between buyer and seller.

COMMENTARY ON SKETCH FOR MECHANISM OF A LETTER OF

CREDIT.

 Buyer directly contacts with the seller to know about the cost of
merchandise; buyer intends to buy. It is known as enquiry.
 Seller would offer the rates of the goods and other terms.
 If those rates and terms are agreed by both of them, they enter into a
written agreement.
 On the basis of that agreement buyer requests his bank to send a letter on
his behalf to the seller to dispatch as per agreement. That agreement
contains name, brand, colour , model, size, number of items, rates, mode
of transportation; indicating who would bear the cost of transportation and
Insurance premium amount, validity of offer and approximate date/period
of shipment of goods.
 Bank sends a letter addressed to the seller (Not The Bank Abroad),
requesting seller to dispatch goods as per terms of this letter, and after
shipment submit set(s) of documents, having proof of shipment of goods
to a bank; nominated by the buyer’s bank. The most important document
is “Document Title to Goods” like Airway Bill, Bill of Lading. Railway
Receipt and Post Parcel Receipt etc. The document depends upon the
mode of transportation agreed between buyer and seller and it is
specifically contained in the letter. This letter is known as Letter of
Credit.
 A copy of this letter is mailed to foreign bank, which would accept
documents from seller.
 No doubt that the letter is addressed to the seller, but it is not mailed to the
seller directly, but through the bank abroad, and buyer’s bank request the
seller’s bank to hand over this letter to the seller.
 Why not to dispatch to seller directly.
 This letter specifically guarantee/undertake to make the payment to the
seller immediately after shipment or on future fixed date if agreement is to
pay on usance basis.
 Now seller is confident that he would surely get the payment for the
goods he would be selling some one abroad, and with whom he has no
other relations and even not knowing buyer otherwise.
 Seller would dispatch the goods, would prepare set(s) of documents
mentioned in letter of credit and would submit to the bank abroad. That
bank after thorough scrutiny would debit the account of buyer’s bank (if
value of letter of credit is stated in the currency of seller’s bank) or if the
currency is alien currency to that bank than that seller’s bank would claim
the amount from other bank on behalf of buyer’s bank and it would be
paid, as in this a copy of this letter of credit is also mailed to that third
bank; authorizing that bank to honour the claim of seller’s bank.
(THIS POINT IS TO BE ELABORATED MORE IN SESSION)
Seller’s bank after making payment to the seller would dispatch documents
to the bank of buyer.
 At this point one end of the guarantee is settled as the seller got his
value for the goods he sold.
 Now the goods are coming to the country of buyer; through Air Craft or
Ship and simultaneously the documents are also traveling from the
country of seller to the country of buyer.
 The goods have been shipped in favour of buyer’s bank and only that
bank is entitled to get the goods released from the carrier or by a nominee
of buyer’s bank. Reason being the buyer’s bank has made the payment to
the seller and this value is yet to be received from the buyer.
 On receipt of documents the buyer’s bank would intimate the buyer and
would request buyer to come and collect documents; after making
payment in local currency.
 As discussed in class that in Pakistan when goods are imported our
importer makes payment in Local currency, where as the buyer’s bank
account was debited in foreign currency. It indicates that the bank has
made payment on behalf of buyer and this payment would be termed as
“Sale of Foreign Currency” to the buyer.
 Later on buyer would come and would authorize it’s bank to debit his
account and hand over the documents, and to remind you these are the
documents on the basis of those the seller received the value of his goods,
and now when the these are being handed over to the buyer; bank would
get it’s money.
 As already stated that Goods were shipped in the favour of buyer’s bank
and only that bank or its nominee is entitled to get the goods released. So
after receiving money from buyer, the buyer’s bank would authorize the
buyer to get the goods cleared and take its delivery. This process of
transferring the title of goods is done through endorsement.
 Now the final end of the guarantee is also settled as the buyer would get
the goods against the value he paid.
 This transaction was only possible through an undertaking given by the
bank and is called “Letter of Credit”
BANKING TERMINOLOGIES FOR ABOVE STATED DEALING

Until now we have been using layman/easy language just to make the students
understand effortlessly. But we being heading toward getting expertise in
International Banking, we must be acquainted with real Banking terms and those
are:-

Document which serves the purpose of

offer from beneficiary, in which description
of goods, with price, brand colour, model
and other terms are stated, signed by the
exporter, and later on when importer accepts it
by signing on its face and submits to the
opening bank as an agreement for establishment
of letter of credit. Performa Invoice

Buyer Importer/Opener of L/c

Seller. Exporter/Beneficiary

Buyer’s Bank Opening Bank.

Seller’s Bank through whom L/c was sent. Advising Bank

Seller’s Bank when making payment to seller. Negotiation Bank

The bank from which negotiating bank

claim reimbursement in case of other currency
known as third bank Reimbursing Bank

Process whereby negotiating bank checks

documents in terms of L/c before making
payment To exporter Negotiation
Finally we must know “What is a Letter of Credit” ?

It is an instrument in shape of a letter issued on behalf of the opener, by opening

bank; addressed to the beneficiary, having an undertaking that he would get the
value of goods shipped by him, but strictly in terms of letter of Credit.

OTHER RELATED TERMINOLOGIES

FOB Free on board

C&F Cost and Freight

CIF Cost Insurance and Freight