How does 'Letter of Credit' work?

A business called the InCosmetika from time to time imports goods from a business called BLISS, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from BLISS, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:

InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit, with BLISS as the beneficiary.

The Commonwealth Bank can issue an LC either on approval of a standard l-oan underwriting process or by InCosmetika funding it directly with a deposit of $500,000 plus fees which are typically between 1% and 8% of the face value of the LC.

The Commonwealth Bank sends a copy of the LC to the ABC Bank, which notifies BLISS that payment is available and they can ship the merchandise InCosmetika has ordered with the full assurance of payment to them.

On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of theletter of credit, the Commonwealth Bank transfers the $500,000 to the ABC Bank, which then credits the account of BLISS for that amount.

Note that banks deal only with documents required in the letter of credit and not the underlying transaction.

Many exporters have mistakenly assumed that the payment is guaranteed after receiving the LC. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met.

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