What is letter of credit and how it works? How letter of credit functions? Typical scheme of activities associated with the letter of credit looks as follows:
1. Buyers and sellers sign the contract, which states that payment for the goods will take place in the form of a letter of credit.
2. The buyer asks his bank – the bank issuing the letter of credit – a request for a letter of credit in favor of the seller (beneficiary). Then bank accepts instructions of the buyer.
3. Issuing bank (in other words: opening) a letter of credit sends request to another bank (usually located in the country of the seller) for advising (transfer) of the content of the letter of credit, or for its validation. If the letter of credit will be confirmed by the bank to the seller, then he adds its own commitment to that which comes from a bank – the issuer.
4. Advising bank (or confirming) informs the seller that the letter of credit has been opened in his favor.
5. As soon as the seller has information about the opening on his behalf the letter of credit, with the certainty that it can exactly meet all the requirements and conditions contained therein, then he is able to proceed to the loading and dispatch of goods sold.
6. Then the seller sends the documents representing the goods to the bank. These documents certify that the shipment has been made in accordance with the conditions contained in the letter of credit. Seller directs the documents to the bank where the letter of credit is available (this can be bank-issuer, the bank confirming or any other bank mentioned in the letter of credit as a bank making the payment or the bank negotiating the promissory note (ie, buying the promissory note from the exporter, while paying him his due), or it may be advising bank or any other bank that is willing to negotiating promissory note within the letter of credit).
7. Bank checks the documents mentioned in the letter of credit. If the documents meet its requirements, the bank:
– accept promissory note, or
– will negotiate promissory note (bill of exchange) under the terms of the letter of credit.
How letter of credit works after that? In case of letter of credit authorizing the opportunity to negotiate bills of exchange, the issuer bank or confirming bank will negotiate without recourse, and any other bank – including a bank advising the letter of credit to seller – will negotiate with him the bill of exhange keeping regress in relation to him.
8. Bank, if it’s the other bank than the issuer bank, sends the documents to the bank issuing the letter of credit.
9. Bank, which issued the letter of credit check documents, and then – if they meet the requirements of the letter of credit, either:
a) make payments in accordance with the terms of the letter of credit, whether it is the seller (if the documents were sent to him directly) or to the bank that provided the funds to the seller in anticipation of the payment from the bank issuer, or
b) transfers the money in the manner previously agreed to the bank confirming or any other bank that paid, accepted the bill of exchange, or negotiated it in the context of the letter of credit.
10. If the documents are checked by the issuing bank and when they are by this bank found to comply with the conditions contained in the letter of credit, will be given to the buyer – of course, after the latter’s contribution of receivable. These documents may also be issued to the buyer on terms agreed by him with the bank issuing the letter of credit.
11. The buyer sends the transport documents to the carrier, who then proceed to deliver the goods. Settlement may be made in the form of:
a) payment in cash.
b) Accepting the bill of exchange.
c) Negotiation (ie, repurchase) of bills of exchange (promissory notes).
And that’s the scheme of how the letter of credit functions between the seller, buyer, bank and carrier.
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