A Letter of Credit is a signed letter from the bank stating the buyer will pay the seller when they meet specific transaction conditions. A quicker way to understand how this letter works is through an example. So, let's take a look at this from a working model.
For instance, imagine a purchaser is buying goods from a seller. Before this trading takes place, both parties agree to sign the letter of credit. However, there are various types of letter-of-credit where the details can vary from shipment to shipment.
Standby Letter of credit is a type of LOC that works as an agreement for various services such as constructing buildings, registering for electrical maintenance, etc. Like this, many LOCs are available for both international and domestic transactions.
Now, let's understand how the movement of money and documents needed for a letter of credit in a step-by-step process.
1. Mutual business needs and requirements
A buyer and a seller have to come together with their business needs and requirements. Then, they accept and comply with the terms for trading. From the price value to the quantity, they discuss everything related to business. As per the agreement, the seller should get the buyer's consent to issue a letter of credit.
You can ask now why the seller needs a LOC? The seller wants a guarantee that the buyer will pay for the services. In some cases, buyers and sellers may not be acquainted at all. So, that's why they conclude to sign a letter of credit. For instance, a documentary letter of credit is when the bank agrees to pay the seller instead of the buyer if they meet specific transaction conditions.
2. Obtaining the LOC
The buyer has to make the initial move of requesting a LOC. In most cases, the buyer's bank is located at his/her native place and is the bank that buyer uses for any business transaction. And what the bank does is collect the required information needed to issue a LOC. For this, the banks must get accurate details from the buyer.
3. Delivering the shipment with the documents
In this step, the seller should comply with the requirements and deliver the goods to the buyer. Once the shipment has been provided, the seller should have the necessary documents for proof of delivery. If the seller meets all the requirements, the payment should follow.
4. Final payment
When the seller has proved that the goods have been delivered, the bank verifies the documents and initiates the seller's payment. If something goes wrong with the papers, the amount to be credited will fail.
