Letter of Credit Process:

In International trade, the buyer and the seller who are located in different countries, may not know
each other and hence many times the problem of Buyers Creditworthiness hampers the trade between
the buyer and the seller. The main objectives of the buyer and the seller in any international trade and
contradictory in terms of Buyer will always try to delay the payment while the seller would like to
receive funds at the earliest.
To mitigate this problem, Seller always request Buyer to arrange for a Letter of Credit to be issued by
Buyers Bank. Upon issuance of Letter of Credit, the Buyers bank replaces its own Creditworthiness to
that of the Buyer, it undertakes to reimburse the Seller for the value of the Letter of Credit
Irrevocably provided two underline conditions are fulfilled by the Seller:
1. All the documents stated in the LC are presented;
2. All the terms and conditions of the LC are complied with.
The beauty of the LC is that if above two conditions are fulfilled, Issuing Bank will effect payment to
the Beneficiary, irrespective of Applicant reimburses the Issuing Bank or not. Thus, a Letter of Credit is
an undertaking issued by a bank in favor of a Beneficiary (Seller), which substitutes the banks
creditworthiness for that of the Applicant (Buyer).

Why Letter?
It is named a Letter because initially the LCs were issued manually in a Letter format address by Issuing
Bank to Beneficiary confirming its conditional undertaking to reimburse the Beneficiary, the amount of
the LC provided above 2 basic conditions are fulfilled.
Parties involved in LC transaction:
1. The Applicant is the party that arranges for the letter of credit to be issued.
2. The Beneficiary is the party named in the letter of credit in whose favor the letter of credit is
issued.
3. The Issuing or Opening Bank is the applicants bank that issues or opens the letter of credit in
favor of the beneficiary and substitutes its creditworthiness for that of the applicant.
4. An Advising Bank may be named in the letter of credit to advise the beneficiary that the letter
of credit was issued. The role of the Advising Bank is limited to establish apparent authenticity
of the credit, which it advises.
5. The Paying Bank is the bank nominated in the letter of credit that makes payment to the
beneficiary, after determining that documents conform, and upon receipt of funds from the
issuing bank or another intermediary bank nominated by the issuing bank.
6. The Confirming Bank is the bank, which, under instruction from the issuing bank, substitutes
its creditworthiness for that of the issuing bank. It ultimately assumes the issuing banks
commitment to pay.
Commercial Letter of Credit Flow
Applicant approaches Issuing/ Opening Bank with LC application form duly filled and requests Issuing
Bank to issue a Letter of Credit in favour of Beneficiary.
1. Issuing Bank issues a Letter of Credit as per the application submitted by an Applicant and
sends it to the Advising Bank, which is located in Beneficiarys country, to formally advise the
LC to the beneficiary.

2. Advising Bank advises the LC to the Beneficiary.

3. Once Beneficiary receives the LC and if it suits his/ her requirements, he/ she prepares the
goods and hands over them to the carrier for dispatching to the Applicant.
4. He/ She then hands over the documents along with the Transport Document as per LC to the
Negotiating Bank to be forwarded to the Issuing Bank.
5. Issuing Bank reimburses the Negotiating Bank with the amount of the LC post Negotiating
Banks confirmation that they have negotiated the documents in strict conformity of the LC
terms. Negotiating Bank makes the payment to the Beneficiary.
6. Simultaneously, the Negotiating Bank forwards the documents to the Issuing Bank to be
released to the Applicant to claim the goods from the carrier.
7. Applicant reimburses the Issuing Bank for the amount, which it had paid to the Negotiating
Bank.
8. Issuing Bank releases all documents along with the titled Transport Documents to the
Applicant.
Settlements Under a Letter of Credit
All commercial letters of credit must clearly indicate whether they are payable by sight payment, by
deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the
terms

of

the

commercial

letter

of

credit.

In a sight payment, the commercial letter of credit is payable when the beneficiary presents the
complying documents and if the presentation takes place on or before the expiration of the commercial
letter of credit.
In a deferred payment, the commercial letter of credit is payable on a specified future date. The
beneficiary may present the complying documents at an earlier date, but the commercial letter of
credit is payable only on the specified future date.

An acceptance is a time draft drawn on, and accepted by, a banking institution, which promises to
honor the draft at a specified future date. The act of acceptance is without recourse as it is a
commitment to pay the face amount of the accepted draft.
Under negotiation, the negotiating bank, a third party negotiator, expedites payment to the
beneficiary upon the beneficiarys presentation of the complying documents to the negotiating bank.
The bank pays the beneficiary, normally at a discount of the face amount of the value of the
documents, and then presents the complying documents, including a sight or time draft, to the issuing
bank to receive full payment at sight or at a specified future date.
Types of Letter of Credit
Irrevocable
An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all
parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise
stated. Here, the importer's bank gives a binding undertaking to the supplier provided all the terms and
conditions of the credit are fulfilled.
Unconfirmed
The advising bank forwards an unconfirmed letter of credit directly to the exporter without adding its
own undertaking to make payment or accept responsibility for payment at a future date, but
confirming its authenticity.
Confirmed
A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank,
has added a confirmation that payment will be made as long as compliant documents are presented.
This commitment holds even if the issuing bank or the buyer fails to make payment. The added security
to the exporter of confirmation needs to be considered in the context of the standing of the issuing
bank and the current political and economic state of the importer's country. A bank will make an
additional charge for confirming a letter of credit. In many cases, the confirming bank is located in
Beneficiarys

country.

Confirmation costs will vary according to the country involved, but for many countries considered a

high risk will be between 2%-8%. There also may be countries issuing letters of credit, which banks do
not wish to confirm - they may already have enough exposure in that market or not wish to expose
themselves to that particular risk at all.
Standby Letters of Credit
A standby letter of credit is used as support where an alternative, less secure, method of payment has
been agreed. They are also used in the United States of America in place of bank guarantees. Should
the exporter fail to receive payment from the importer he may claim under the standby letter of
credit. Certain documents are likely to be required to obtain payment including: the standby letter of
credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a
signed declaration from the beneficiary stating that payment has not been received by the due date
and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce
publishes rules for operating standby letters of credit - ISP98 International Standby Practices.
Revolving Letter of Credit
The revolving credit is used for regular shipments of the same commodity to the same importer. It can
revolve in relation to time or value. If the credit is time revolving once utilised it is re-instated for
further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once
utilised and paid the value can be reinstated for further drawings. The credit must state that it is a
revolving letter of credit and it may revolve either automatically or subject to certain provisions.
Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or
amending letters of credit.
Transferable Letter of Credit
A transferable letter of credit is one in which the exporter has the right to request the paying, or
negotiating bank to make either part, or all, of the credit value available to one or more third parties.
This type of credit is useful for those acting as middlemen especially where there is a need to finance
purchases from third party suppliers.
Back-to-Back Letter of Credit

A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather
than transferring the original letter of credit to the supplier, once the letter of credit is received by
the exporter from the opening bank, that letter of credit is used as security to establish a second letter
of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-toback letters of credit due to the level of risk to which they are exposed, whereas a transferable credit
will not expose them to higher risk than under the original credit.
Advantages of Letter of Credit:
1. The beneficiary is assured of payment as long as it complies with the terms and conditions of
the letter of credit. The letter of credit identifies which documents must be presented and the
data content of those documents. The credit risk is transferred from the applicant to the
issuing bank.
2. The beneficiary can enjoy the advantage of mitigating the issuing banks country risk by
requiring that a bank in its own country confirm the letter of credit. That bank then takes on
the country and commercial risk of the issuing bank and protects the beneficiary.
3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the
receivables.
4. The beneficiarys foreign exchange risk is eliminated with a letter of credit issued in the
currency of the beneficiarys country.
Risks involved in Letter of Credit.
1. Since all the parties involved in Letter of Credit deal with the documents and not with the
goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists.
2. The Letter of Credit as a payment method is costlier than other methods of payment such as
Open Account or Collection
3. The Beneficiarys documents must comply with the terms and conditions of the Letter of Credit
for Issuing Bank to make the payment.
4. The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the Issuing
Banks country and Foreign Exchange Risk in case of Usance Letter of Credits.

Advantages of Using Letters of Credit

For Exporters
Guaranteed payment upon presentation of the documents specified in the terms of the letter of credit.
Reducing the production risk, first of all, for the situations when the buyer cancels or changes his order.
The ability to structure the delivery schedule according to the exporter's interests.
The chance to obtain financing for production or purchase of goods (pre-export finance).
The chance to get financing in the period between the shipment of the goods and receipt of payment (especially, in
case of delayed payment).
The buyer cannot refuse to pay due to a complaint about the goods.
The importer must raise any complaints/claims about the delivered goods separately from the letter of credit, which
provides the exporter with a significant advantage in resolving such issues.
Using documentary letters of credit allows the exporter to significantly reduce the risk of non-payment for delivered
goods, as in case of presentation of fully credit conform documents by the seller, the issuing bank pays the agreedupon amount independently of the importer.
In order to use Aizkraukles Banka services to accept documentary letters of credit as a form of payment, you just
need to have a current account with the bank.
For Importers
The possibility to structure the payment plan in the contract according to the importer's interests.
Certainty that the payment will be made only upon presentation of the documents confirming shipment of the
goods.
The use of a letter of credit allows the importer to avoid or reduce pre-payment.
The seller must fulfill all terms of the contract, as indicated in the letter of credit (shipment of the goods, meeting
delivery terms on stock, amount, and deadlines) in order to receive the payment.
Having opened a letter of credit, the importer proves his ability to pay and can count on more favourable payment
terms in the future.
Documentary letters of credit help the importer significantly reduce the risk connected with the seller not meeting its
delivery obligations. The imported goods will be delivered in accordance with all the conditions specified in the
letter of credit, and the agreed-upon documents will be received relatively quickly.