By its nature, a L/C is an independent payment mechanism, separate from the sales contract or other agreement on which it may be based.
Banks examine the documents and not the goods or the execution of services to which the documents are related. L/Cs can relate to goods and/or services and be international or domestic (where buyer and supplier are in the same country).
A documentary credit (also known as L/C or Letter of Credit) is a payment instrument and a payment guarantee at the same time. It is an irrevocable commitment of the buyer’s bank in favour of the supplier, to honour a presentation (e.g. to pay at sight, or to undertake to defer a payment and to pay at maturity, or to accept a draft drawn by the beneficiary and to pay it at the maturity according to the case), provided that the supplier submits a complying presentation.
Submitting a complying presentation means that the supplier presents the documents specified in the L/C, fully conform to the terms of the L/C and the applicable international rules.
There are at least four parties in the L/C structure;
Applicant: the party on whose request the L/C is issued: the buyer.
Beneficiary: the party in whose favour the L/C is issued: the seller/the supplier.
Issuing bank: the bank that issues the L/C (the buyer’s bank)
Advising bank: the bank that informs the supplier of the content of the L/C as soon as it has ascertained the authenticity of the L/C received (usually the supplier’s bank). It is also called “notifying bank”. Mostly this bank also add it’s confirmation on the L/C as “confirming bank”
The terms of Letters of Credit;
Sight payment: means payment upon presentation of the documents. It should be noted that payment “at sight” usually requires processing time that may vary according to the terms specified by the issuing bank in field 78 and the structure of the documentary credit.
Deferred payment: means payment at the maturity date(s) specified in the credit (e.g. 90 days from the date of the bill of lading or 60 days from the invoice date, 120 days from the issuance date etc.).
By acceptance: means payment on the due date of one or more drafts drawn by the beneficiary on the nominated bank (the bank with which the documentary credit is available).
By negotiation: means that the exporter has the option to obtain an advance of the amount of the documents presented to the nominated bank. This option is particularly useful when the documentary credit is payable at maturity. The beneficiary indeed is paid promptly after shipment and you, the applicant, pay on the due date agreed in the documentary credit.