There is no shortage of complex paperwork and documentation in the maritime world. You may know the more important bill of lading and packing list etc. But there are other equally important ones. In this article, we'll learn more about a letter of credit, what it is, and how it works.
What is a letter of credit?
According to the International Chamber of Commerce, a letter of credit is:
“On behalf of the buyer (customer/importer), the bank undertakes to pay the seller (beneficiary/exporter) the specified amount in the agreed currency, provided that the seller submits the required documents within the predetermined period.”
In other words, a letter of credit is a way, and one of the most common, where an importer promises to pay its foreign seller. It acts as a formal, binding legal agreement. Additionally, shippers generally consider this to be one of the safest payment methods.
In every transaction, there are sellers and buyers. In the vast world of trade, there is no way to know if the person you are dealing with is reliable. Given that it takes a long time for the goods to arrive by sea, the importer needs to guarantee payment before the goods arrive. This guarantee comes in the form of a letter of credit.
How does a letter of credit work?
It serves as a regular instruction from the importer's bank to the bank guaranteeing advance payment to the exporter. However, this first requires both parties to meet certain requirements. Buyers usually set these terms and conditions, which usually include:
- Port of departure and port of destination
- Shipping method
- Route
- Product description, including technical description (if applicable)
- Number of Products
- Needed file
- Consignee details
- Notifying Party Details
- Latest shipping date
Once the seller agrees to these terms, the buyer's bank (or issuing bank) proceeds to issue the letter of credit. This will be sent to the seller and his bank (designated bank). According to these conditions, the seller prepares his goods and documents. After shipment, the seller will bring the copy of the document to the designated bank for verification.
When the nominated bank verifies that the documents match those listed on the letter of credit, it pays the seller. Then it goes to the issuing bank with the documents. The issuing bank then certifies itself. Upon satisfaction, it will refund the amount paid to the seller to the nominated bank.
When complete, it notifies the buyer that the shipment is complete and that all documents are correct and in their possession. The buyer then pays the issuing bank, which signs the bill of lading to allow the goods to be released to the buyer.
