An import letter of credit is a type of guaranteed payment arrangement in international trade made by importers, or buyers, to ensure payment to exporters, or sellers. It is known as a “documentary credit” because it is a payment predicated on the presentation to the guaranteeing bank of a certain set of trade documents. The effectiveness of international letters of credit is governed by the International Chamber of Commerce and the trade law known as the Uniform Customs and Practice for Documentary Credits.
The procedure for purchasing goods from a merchant in a foreign country is rather complex. There are currency exchange issues and differences in political and economic stability that can impact the flow of money between countries. Beyond the inherent risks of dealing with a foreign country with a different financial system, the time lapse between when an order is placed and the goods received creates an additional risk for one of the parties. Either the buyer must pay for the goods in advance and wait for arrival, running the risk that the seller never sends the goods at all, or the seller must send the goods in advance and wait for payment upon receipt, running the risk that the buyer takes the goods but never pays.
To minimize these transactional risks, a bank acts as an intermediary, guaranteeing payment to the seller and allowing him to ship his goods without fear of fraud. The import letter of credit system functions almost like an escrow service, where money and goods are released once a third party is satisfied by proof of performance. There are two banks involved in the sales transaction. The importer's bank issues the import letter of credit and is known as the issuing bank. Exporters deal with their own bank, known as the advising bank, to process the payment guaranteed by the letter of credit.
An ordinary import letter of credit is an irrevocable guarantee of payment issued by a bank. A buyer arranges for the document to be drawn on his bank once he has an executed sales contract with the exporter. The letter of credit specifies the terms that need to be satisfied in order for the bank to pay out the guaranteed money and is given to the exporter, who then ships his goods. He receives a bill of lading, or proof of shipment, when he sends out the goods.
The exporter takes the bill of lading and the import letter of credit along with any other documents required to his bank. His bank presents the documents on his behalf to the issuing bank, which releases the money in exchange for the documents. The issuing bank sends the bill of lading to the buyer, who can use it to pick up his goods from customs.