How a simple Letter of Credit Works

Imagine that one of our UK companies from time to time imports computers from a business called Beijing Computers, which banks with the Shanghai Business Bank. Our company ("XCo") holds an account at HSBC. XCo want to buy $500,000 worth of merchandise from Beijing Computers, who agree to sell the goods and give XCo 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:

• XCo goes to HSBC and requests a $500,000 letter of credit, with Beijing Computers as the beneficiary.
• HSBC can issue an LC by XCo funding it directly with a deposit of $500,000 plus fees (minimum 1%+ can run as high as 8%).
• HSBC sends a copy of the LC to the Shanghai Business Bank, which notifies the Beijing Computers that payment is ready and they can ship the merchandise we have ordered with the full assurance of payment to them.
• On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, HSBC transfers the $500,000 to the Shanghai Business Bank, which then credits the account to the Beijing Computers by that amount.

Note that banks deal only with documents under the letter of credit and not the underlying transaction.

Many exporters have misunderstood that the payment is guaranteed after receiving the LC. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met accordingly

1. After a contract is concluded between a buyer and seller, the buyer's bank supplies a letter of credit to seller.
2. Seller consigns the goods to a carrier in exchange for a bill of lading.
3. Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from buyer.
4. Buyer provides bill of lading to carrier and takes delivery of goods.

NB: Typically, the documents a beneficiary has to present in order to avail himself of the credit, are commercial invoice, bill of lading, insurance documents. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped.