How does Letter of Credit Work?

LC is an arrangement whereby the issuing bank can act on the request and instruction of the applicant (importer) or on their own behalf. Under an LC arrangement, the issuing bank can make a payment to (or to the order of) the beneficiary (that is, the exporter). Alternatively, the issuing bank can accept the bills of exchange or draft that are drawn by the exporter. The issuing bank can also authorize advising or nominated banks to pay or accept bills of exchange.

There are various fees and reimbursements involved when it comes to LC. In most cases, the payment under the letter of credit is managed by all parties. The fees charged by banks may include: Opening charges, including the commitment fees, charged upfront, and the usance fee that is charged for the agreed tenure of the LC. Retirement charges are payable at the end of the LC period. They include an advising fee charged by the advising bank, reimbursements payable by the applicant to the bank against foreign law-related obligations, the confirming bank’s fee, and bank charges payable to the issuing bank.

Applicant: An applicant (buyer) is a person who requests his bank to issue a letter of credit.

Beneficiary: A beneficiary is basically the seller who receives his payment under the process.

Issuing bank: The issuing bank (also called an opening bank) is responsible for issuing the letter of credit at the request of the buyer.

Advising bank: The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter.

Other parties involved in an LC arrangement:

Confirming bank: The confirming bank provides an additional guarantee to the undertaking of the issuing bank. It comes into the picture when the exporter is not satisfied with the assurance of the issuing bank.

Negotiating bank: The negotiating bank negotiates the documents related to the LC submitted by the exporter. It makes payments to the exporter, subject to the completeness of the documents, and claims reimbursement under the credit.

Reimbursing bank The reimbursing bank is where the paying account is set up by the issuing bank. The reimbursing bank honors the claim that settles the negotiation/acceptance/payment coming in through the negotiating bank.

Second Beneficiary The second beneficiary is one who can represent the original beneficiary in their absence. In such an eventuality, the exporter’s credit gets transferred to the second beneficiary, subject to the terms of the transfer.

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