How do Letters of Credit work?

Question

A step by step guide through the process would be very helpful.

Answer 1

Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism.

A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.

Elements of a Letter of Credit
* A payment undertaking given by a bank (issuing bank)
* On behalf of a buyer (applicant)
* To pay a seller (beneficiary) for a given amount of money
* On presentation of specified documents representing the supply of goods
* Within specified time limits
* Documents must conform to terms and conditions set out in the letter of credit
* Documents to be presented at a specified place

The above is extracted from the lecture Understanding and Using Letters of Credit. The whole lecture is available at the link.

Answer 2

Is works this way if you would like it in simple words. Your seller doesn't trust you. He is overseas let's say. He doesn't want to ship you his product until you pay. But you are also afraid that if you pay he will not deliver the goods. That's what LC was created for. It's all between banks to avoid all risks. Your bank promises seller's bank to pay against the shipment documents, which must be presented in due time. Of course banks follow strict rules and they will not defer the payment or anyhow mess the agreement. So you pay for the LC issuance and sleep well. The same does the seller accepting your LC) You can get it from the bank or from the LC direct provider for a lower fee. We are usually using these guys for it. They issue only for 10% commission against their own collateral.

Answer 3

L/C does not always require collateral. You just need to credit worthy.
They are very simple. The issuing bank is guaranteeing payment (up to whatever they approve for you at the time of issue). There are specific instructions on how to cash it within the body of the agreement.
There are different L/C also; payment, performance and guaranty. All have different triggers that would allow for payment.

Answer 4

Simply stated, a Letter of Credit is just a bank's guarantee to a third party that they will pay a debt which you intend to incur.
To get a bank to issue such a L/C you will have to supply them with securities such as bonds, stocks, or other valuable consideration to allow them to cover your debt in the event that you do not repay them in due time.
Check with your bank to see exactly what their procedure is.