L/C is a written commitment to pay, by a buyer's or importer's bank (called the issuing bank) to the seller's or exporter's bank (called the accepting bank, negotiating bank, or paying bank).
These documents almost always include-
1. a clean bill of lading or air waybill,
2. commercial invoice, and
3. certificate of origin.
To establish a letter of credit in favour of the seller or exporter (called the beneficiary) the buyer (called the applicant or account party) either pays the specified sum (plus service charges) upfront to the issuing bank or negotiates credit.
Letters of credit are formal trade instruments and are used usually where the seller is unwilling to extend credit to the buyer. In effect, a letter of credit substitutes the creditworthiness of a bank for the creditworthiness of the buyer. Thus, the international banking system acts as an intermediary between far-flung exporters and importers.
However, the banking system does not take on any responsibility for the quality of goods, genuineness of documents, or any other provision in the contract of sale. Since the unambiguity of the terminology used in writing a letter of credit is of vital importance, the International Chamber Of Commerce (ICC) has suggested specific terms (called Incoterms) that are now almost universally accepted and used.
Unlike a bill of exchange, a letter of credit is a nonnegotiable instrument but may be transferable with the consent of the applicant. Although letters of credit come in numerous types, the two most basic ones are:
(1) Revocable-credit letter of credit and
(2) Irrevocable-credit letter of credit, which comes in two versions as-
- Confirmed irrevocable letter of credit and
- Not-confirmed irrevocable letter of credit.