A letter of credit is the most common payment instrument used in foreign trade because it offers protection to both parties in the transaction. When the process of the L/C is followed, the instrument ensures payment for the supplier, and shipment for the buyer, as well as allowing for provisions to control the quality and quantity of the goods for the importer. These 14 steps overview how an L/C works:

Step 1: The buyer and seller agree terms, including means of transport, period of credit offered, latest date of shipment and the relevant Inco-term to be used.

Step 2: The buyer applies to the bank for a letter of credit to be issued.

Step 3: The bank will then evaluate the buyer's credit rating, and may require cash cover and/or reduction of other lending limits.

Step 4: The issuing bank will issue a letter of credit. This will be sent to the advising bank by airmail, telex or SWIFT.

Step 5: The advising bank will establish authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary).

Step 6: The advising bank may confirm the letter of credit, i.e. add its own payment undertaking.

Step 7: The seller should check that the letter of credit matches the commercial agreement, and that the terms and conditions can be satisfied in goodtime.

Step 8: If there is anything that may cause a problem, an amendment should be requested.

Step 9: The seller ships the goods and gathers together all the documents asked for in the letter of credit including the invoice, bill of lading, insurance policy certificate, as well as the certificates of origin and quality.

Step 10: Before presenting the documents to the bank, the seller should check them for discrepancies against the letter of credit, and correct the documents where necessary.

Step 11: The documents are presented to one of the banks, usually the advising bank.

Step 12: The advising bank checks the documents against the letter of credit. If the documents are compliant, the bank pays the seller and forwards the documents to the issuing bank.

Step 13: The issuing bank will also check the documents. If they are in order the issuing bank will reimburse the seller's bank immediately.

Step 14: The issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier.

It should be noted that the letter of credit refers to documents representing the goods, and not the physical goods themselves. The banks do not examine the goods on behalf of their customers but instead only care about the documents representing the goods.

The following problems frequently occur when letters of credit are used and can be prevented with due care:

Tip: Exporters and importers must coordinate the wording of all documents before submission, using the same criteria that the banks apply. Ensure that all the terms used match.

The banks use limited discretion in matching the terms and conditions of the L/C against documents presented. There is often little room for judgment. For example, suppose that a letter of credit describes goods as "cocoa butter with a maximum fat content of 15%". However the exporter presents a commercial invoice referring to the goods as "cocoa butter with 12% fat content". Common sense would suggest that this consignment would be accepted; yet some banks will reject the documents on the grounds of a discrepancy in the goods description.

Tip: Often the letter of credit fails to anticipate an aspect of the transaction. To avoid such problems, exporters need an understanding of the different types of commercial document (transport document, insurance document, etc.) and the things on each document that may matter to a bank in the context of presentation under a letter of credit.

For example a common requirement on a letter of credit is for a 'clean on-board bill of lading' - a document supplied by the shipping company attesting that the goods were received in apparently good condition, and were loaded in the ship's hold. However if the goods are hazardous or flammable, they will be put on the deck of the ship instead of the hold, and the bill of lading will be marked 'on deck'. This is not an on-board bill of lading, so the bank can reject the documents.

Tip: Time limits can be missed when presenting required documents. The parties must be aware of up to three time constraints - the expiry date of the credit, the latest shipping date and the maximum time allowed between dispatch and presentation.

Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits. If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to organize. After dispatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.

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