Letter of Credit LOC - commercial letter of credit

A "commercial letter" of credit is a payment mechanism that is used to eliminate risks in the international trade. Please note the emphasis on the payment mechanism.  A letter of credit guarantees the supplier of goods that he will receive a payment in exchange for documents specified on a letter of credit.  It is a handy tool when taking into account the uncertainty of the international trade such as: different laws, distance, no personal knowledge of the parties involved. A letter of credit also protects the buyer, making sure the seller won’t receive his or her payment until the goods are shipped.

To better understand this complex process we have created a visual map below:

We will assume a few things, the paying bank is the advising bank and Incoterms are FOB

Now each step in detail:

1.)    A sales contract is concluded between a buyer and a seller. A sale contract can be a Performa Invoice, a formal agreement , purchase order.

2.) The buyer applies for a letter of credit

3.) The buyer's bank reviews the application, and requests the buyer to make a deposit.

4.) The buyer's bank forwards the LOC to the seller's bank(advising bank).

5.) Seller's bank reviews the LOC

6.) The seller's bank provides LOC to the shipper(seller)

7.) The seller reviews the LOC, if there are no objections, the goods are tendered to a carrier.

Now at this stage the goods might also need to be inspected if mentioned on a LOC.

8.)Upon receipt, a carrier issues a Bill of landing(BOL) to a shipper.

9.)The seller passes the documents to the seller's bank.

10.) Seller's bank reviews the documents, if everything is ok, releases the funds(in this example, the advising bank is the paying bank)

11.)The advising bank recuperate the costs from the issuing bank and submits the shipping documents to the buyers bank.

12.)The issuing bank forwards the documents to the buyer, so he can take possession of his goods.


Few things to note:

• A stand by LOC = something went wrong, A stand by LOC will be used to recuperate the costs by the seller.

• A commercial LOC = a primary method of payment

• LOC is not part of the sales agreement, it is a separate document issued by a bank.

• Beneficiary - the seller or ultimate recipient of funds

• Bank as an official figure can guarantee a payment. Seller would more likely to trust an official figure to issue a letter of credit.

• Usually used for transactions of $20,000 or over.