Mechanism of a Letter of Credit

Mechanism of a Letter of Credit:

A letter of credit is a very common and familiar instrument in settling payments between the buyer and the seller. Buyers and sellers negotiate for purchase and sale of goods, sellers demanding cash or the buyer's banker's letter of credit as guarantee for payment before they undertake shipment. A letter of credit reinforces the buyer's integrity by adding to it his banker's undertaking. A documentary credit is a signed instrument embodying an undertaking by the banker of a buyer to pay his seller a certain sum of money on presentation of documents evidencing shipment of specified goods and subject to compliance with the stipulated terms and conditions. In order to bring uniformity in matters pertaining to documentary credits, the International Chamber of Commerce (lCC) have published a set of Rules (called UCPDC) wherein a documentary credit has been defined as any arrangement, however, named or described, whereby a bank (the issuing bank) acting at the request and on the instructions of a customer (the applicant for the credit) or on its own behalf is to make payment to or to the order of a third party (the beneficiary) or to accept and pay bills of exchange drawn by the beneficiary authorizes another bank to effect such payment or to accept and pay such bills of exchange or authorizes another bank to negotiate against stipulated documents and compliance with stipulated terms and conditions.

Banks handling documents under a credit are guided by the UCPDC Rules.

A documentary credit generally requires that drafts drawn there under (representing only claim) must be accompanied by other documents as stipulated therein, giving title to the goods, providing protection against loss or damage to the goods and furnishing other information and particulars. Bills of Lading, Marine Insurance Policies / Certificates. Commercial Invoice, Customs Invoice. Certificate of Origin, Weight List, Packing List, Inspection Certificate, Certificate of Analysis and / or other documents as may be stipulated, are such documents.

When a person, who ships goods in reliance on a letter of credit issued by a bank, does so in exact compliance with its terms, the bank concerned is bound to honour his draft if drawn and presented in strict accord with the credit as opened. The paying or the confirming bank can claim indemnity if the terms and conditions of the credit are strictly observed for which it must examine all the documents with care. .

The parties to a Letter of Credit are the importer or the opener, the opening bank, the advising bank, the negotiating bank (also known as paying bank), the confirming bank (if the advising bank adds its confirmation to the credit at the request of the opening bank) and the beneficiary or the exporter.

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