A letter of credit is a contract among four parties: the buyer and their issuing bank, the supplier and its negotiating bank. Here's how a letter of credit works:
1.The buyer asks their supplier if they can pay by way of a letter of credit; The buyer and supplier agree with payment terms and sign a contract.
2.The buyer selects a credit facility and applies for a letter of credit from their issuing bank.
3.The issuing bank issues a letter of credit to the seller’s designated bank, guaranteeing that the payment will be made once the documents have been provided and approved. This includes both clean documents per L/C clauses, and documents with discrepancies that the buyer has accepted.
4.The supplier’s designated bank notifies the seller that the letter of credit has been received.
5.The supplier creates the order for the buyer and ships the goods pursuant to such order.
6.The supplier presents documents to its negotiating bank that prove the L/C order has been fulfilled.
7.The negotiating bank reviews the documents and sends them to the supplier's issuing bank.
8.The buyer’s issuing bank makes the payment (for sight L/C)/or acceptance (for usance L/C), to the negotiating bank after checking and accepting the documents. The documents will then be released to the buyer once the buyer pays (for sight L/C) or promises to pay later (for usance L/C) to the issuing bank. If there is any discrepancy in the documents, the buyer’s issuing bank will refuse to pay, subject to the further decision of the buyer.
9.The negotiating bank release the payment to the seller once they have received the funds from the buyer’s issuing bank.