How does a letter of credit work?

When it comes to ocean freight, documentation is critical to ensure that shipping goes smoothly. Although the bill of landing and the packing list are probably the most common types of transport documents you may have heard about, letters of credit are just as important.

What are letters of credit?

A letter of credit is basically an essential payment instrument in maritime transport and international trade. These letters of credit are used not only for imports, but also for exports. Its importance lies in the fact that through these documents, banks can make or, where appropriate, receive payment from a third party against the delivery of the documentation, whether of the shipment or the maritime transport of goods.

Sometimes known as documentary credits, letters of credit are tools used for the importer to commit and make the corresponding payment to the seller abroad.

Today they are considered the most convenient and secure payment instrument in maritime transport, because in global trade, if you do not have a prior relationship between buyer and seller, it is difficult to know if the person or company you are dealing with is trustworthy.

This is where the letter of credit comes into play since traders need to be certain that the payment will be made in time before the buyer takes control of the cargo. Letters of credit cover precisely this guarantee.

How do letters of credit work?

Letters of credit function as a payment order that the importer’s bank must give to the exporter’s bank. This ensures that the payment is made to the exporter in advance.

For the payment to be made, both parties must meet agree on certain requirements, such as:

• Deadline when the load can be shipped
• The different modes of transport
• The shipping company
• Details of the person or figure who will receive the notifications
• Description of the cargo, including technical aspects
• Required documentation
• The source port and the destination port
• The total amount of the load
• Description and details of the consignee

Once these conditions have been accepted, the issuing bank is in charge of speeding up the process to issue letters of credit. The documents are then sent to the seller and the correspondent bank. Taking into account all the conditions, the seller makes sure to prepare the cargo and the corresponding documents. When the cargo has been shipped, the seller sends copies of the documentation to the correspondent bank for verification. Once the bank verifies that everything is correct, it makes the payment to the seller, who in turn goes to the issuing bank with the documentation to carry out its own verification.

The issuing bank then notifies the buyer that the shipment has been carried out and that the documentation is correct.

Finally, the buyer makes sure to pay the issuing bank, which in turn allows the buyer to release the cargo.

Why is it essential to use letters of credit?

In principle, because it guarantees that the same risks undertaken by the buyer are also undertaken by the seller. In addition, a letter of credit provides protection to the seller in the sense that it guarantees payment as long as buyer and seller meet the conditions agreed in the document.

It also protects the buyer, since if the seller for some reason does not ship the cargo, the buyer can then stop the letter of credit.

In conclusion, the main benefits of letters of credit are:

• Payment is carried out against the documentation that represents the load
• It is a highly secure payment instrument for both the buyer and the seller, as well as being internationally recognized
• For the exporter it guarantees the integrity of its payment
• For the importer, it ensures that the cargo is delivered based on the stipulated conditions.