Open Trade Bangladesh
Lesson 1 of 8 · Level 1 · Basics

A bank's promise

What a letter of credit really is, who the people in it are, and why a bank's promise on paper lets strangers on two continents trust each other.

Remember Evelyn from the How trade works room? She runs a garment factory in Gazipur. A buyer in Hamburg wants 20,000 T-shirts. She has never met him. He has never seen her factory.

Evelyn thinks: "If I ship first, will he pay?" The buyer thinks: "If I pay first, will the shirts ever come?" Both are right to worry. Neither will move first.

So they bring in someone both of them trust: a bank. The buyer's bank writes Evelyn a promise: "Ship the shirts, bring us the right papers on time, and we will pay you." That promise is a letter of credit, or LC. In this lesson we open it up and look inside.

Part 1

What an LC really is

In plain words

A letter of credit is a bank's written promise to pay the seller, on one condition: the seller must present the documents the LC asks for, within the dates it sets, and the documents must match its terms.

Three things make this promise strong:

  • It comes from a bank, not from the buyer. Evelyn no longer depends only on a stranger in Hamburg.
  • It can't be cancelled on a whim. Under the ICC rules most LCs follow (UCP 600), an LC can't be changed or cancelled without the agreement of the seller, the issuing bank and any bank that has added its own promise.
  • It is conditional, but the conditions are on paper. If the papers are right, the bank pays. Simple to say, and, as we will see, it needs care to do.
In everyday life

Think of a university scholarship letter: "We will pay your tuition, as long as you enrol by 1 March and send your mark sheet." The university doesn't care how you travel to campus or which hostel you choose. It cares that the conditions written in the letter are met, on time, with the right papers.

Key words
Letter of credit (LC)
A bank's promise to pay the seller, as long as the seller presents the right documents on time.
UCP
Uniform Customs and Practice for Documentary Credits. The ICC rule book for LCs (current version: UCP 600).
Irrevocable
Can't be changed or cancelled without the agreement of the seller and the banks that gave their promise. Under UCP 600, every LC is irrevocable.
Part 2

Who's who in an LC

In plain words

An LC has its own cast, each with a formal name you will meet again and again:

  • Applicant: the buyer (importer) who asks his bank to open the LC. Here, the buyer in Hamburg.
  • Beneficiary: the seller (exporter) who will be paid. Here, Evelyn.
  • Issuing bank: the buyer's bank that opens the LC and makes the promise to pay.
  • Advising bank: a bank in the seller's country (often Evelyn's own bank in Dhaka) that checks the LC appears genuine and passes it to her. Advising alone is not a promise to pay.
  • Confirming bank: a bank that adds its own promise to pay, on top of the issuing bank's, at the issuing bank's request. Useful when the seller worries about the issuing bank or its country.
  • Nominated bank: the bank named in the LC where the seller can present documents and may get paid. Sometimes any bank can play this role.

One bank can wear more than one hat. Evelyn's bank, for example, may advise the LC, confirm it if asked, and act as the nominated bank too.

In everyday life

Picture renting your flat to a new tenant who works abroad. His employer writes you a letter: "We will pay his rent from his salary" (the issuing bank's promise). Your cousin, who knows that company, checks the letter is real and hands it to you, but promises nothing himself (the advising bank). If your well-off mama adds, "And if they don't pay, I will" (the confirming bank), you now hold two promises. You sleep better.

Key words
Applicant
The buyer (importer) who asks a bank to open an LC.
Beneficiary
The seller (exporter) in whose favour the LC is opened, and who will be paid under it.
Issuing bank
The buyer's bank that opens the LC and promises to pay against the right documents.
Advising bank
A bank in the seller's country that checks an LC appears genuine and passes it to the seller, without promising to pay.
Confirming bank
A bank that adds its own promise to pay to an LC, on top of the issuing bank's promise.
Nominated bank
The bank named in the LC where the seller may present documents and be paid.
Part 3

A promise that stands on its own

In plain words

Evelyn and the buyer have a sales contract. The LC is born from that contract, but once it is issued, it stands on its own.

The bank's promise depends only on the LC's own terms. It does not depend on what the contract says, on any quarrel between buyer and seller, or on whether the buyer is now happy with the deal. Even if the LC mentions the contract, the bank is not bound by the contract.

Why? Because a bank can't judge every trade dispute in the world. If buyers could stop payment by saying "I'm not happy with the seller", the promise would be worth very little, and no seller would trust it.

For the same reason, the LC's terms must be clear and complete. Whatever the buyer truly needs (the latest shipment date, the documents, the inspection certificate) must be written into the LC, not left in the contract.

In everyday life

Say you buy a bus ticket from Dhaka to Sylhet. On the way, you argue with the passenger next to you about the window seat. The bus company still owes you the trip: your ticket is a promise between you and the company, separate from any quarrel on the bus.

Key words
Sales contract
The agreement between buyer and seller on goods, price, delivery and payment.
Independence principle
The idea that an LC is separate from the sales contract: the bank's promise depends only on the LC's own terms.
Part 4

Documents, not goods

In plain words

Here is the idea that surprises most beginners: banks deal in documents, not in goods.

The bank never opens a carton or counts T-shirts. It checks the papers: the invoice, the bill of lading, the packing list, the certificate of origin, and whatever else the LC asks for. If the papers, on their face, fit the LC and don't conflict with each other, the bank pays.

This cuts both ways:

  • Good for Evelyn: if her papers are right, she gets paid, even if the buyer later grumbles about the colour.
  • A warning for the buyer: the LC protects him only as far as the documents go. If he wants proof of quality, he must ask for it in the LC, for example an inspection certificate from a named company.

In rare cases of proven fraud, courts in many countries can step in and stop payment. That is the exception, not the rule.

In everyday life

An exam board marks your answer script, not your brain. If you knew everything but wrote the wrong roll number, the script still has a problem. If your answers on paper are right, you pass, even if you were nervous inside. Banks are exam boards for trade papers.

Key words
Bill of Lading (B/L)
Shipping document for sea cargo: the carrier's receipt for the goods and, when negotiable, the document of title that lets the holder claim them.
Inspection certificate
A report from an independent company that checked the goods' quantity or quality before shipment.
Discrepancy
A difference between the documents and the LC terms, or between the documents themselves. It can delay or stop payment.
Part 5

Why everyone signs up, and what it costs

In plain words

An LC gives something to everyone:

  • The seller swaps the buyer's risk for a bank's risk, and can often get finance against the LC (a back-to-back LC for fabric, or early payment against documents).
  • The buyer pays only when papers show the goods were shipped by the agreed date, and often gets time to pay (a usance LC).
  • The banks earn fees for the risk and work they take on.

But it isn't free:

  • Fees: for opening, advising, confirming, amendments and discrepancies.
  • Bank limits and margin: the issuing bank counts the LC against the buyer's credit limit and may ask him to keep some money aside as margin.
  • Paperwork: one wrong date or one mismatched name can delay payment.
  • Bank and country risk: the promise is only as good as the bank behind it. That is why sellers sometimes pay extra for confirmation.

In Bangladesh, an importer opens an LC through an AD branch of his bank, and an exporter's LC comes in through one. That is why LCs sit at the heart of a trade banker's day.

In everyday life

Buying a flat through a lawyer and a bank costs more than shaking hands with the seller over tea. You pay the fees because the deal is big, the seller is a stranger, and a mistake would hurt.

Key words
Back-to-back LC
An import LC opened on the strength of an export LC, common in garments.
Usance
A credit period: the buyer pays a set number of days later, for example 90 days from sight or from the shipment date.
LC margin
Money the buyer keeps aside with the bank as security when the LC is opened.
AD (Authorised Dealer)
A bank branch licensed by Bangladesh Bank to deal in foreign exchange.
Where to read more
Putting it together

So far: an LC is a bank's written promise to pay the seller against the right documents, on time. It has its own cast (applicant, beneficiary, issuing, advising, confirming and nominated banks). It stands apart from the sales contract, and banks deal in documents, not goods. It costs fees and care, and in return strangers can trade with confidence.

Next: we follow one LC through its whole life, from the buyer's application to the day the money reaches Evelyn.

Check yourself

30 questions, in 3 sets of up to 10. Nobody sees your answers but you.

Set 1 of 3

1. Under an LC, what must the seller do to get paid?
2. Evelyn's bank in Dhaka checks that the LC appears genuine and passes it to her, but adds no promise. What is its role?
3. The buyer is unhappy with the shirts' colour, but Evelyn's documents fully match the LC. What happens?
4. Why might a seller ask for a confirmed LC?
5. In an LC, who makes the promise to pay the seller?
6. True or false: under UCP 600, an LC is irrevocable even if it doesn't say so.
7. After the LC is issued, the buyer finds a cheaper supplier and wants to cancel it. Can he do it alone?
8. Which ICC rule book do most letters of credit follow?
9. In Evelyn's deal, who is the applicant?
10. In Evelyn's deal, who is the beneficiary?

Set 2 of 3

11. Which bank adds its own promise to pay, on top of the issuing bank's?
12. True or false: by advising an LC, the advising bank promises to pay the seller.
13. What is the nominated bank?
14. Can one bank play more than one role in the same LC?
15. A confirming bank adds its confirmation at whose request or authorisation?
16. True or false: if the LC mentions the sales contract, the bank must check the contract before paying.
17. Why is an LC kept separate from the sales contract?
18. The buyer needs the shirts shipped by 30 November. Where must that date be written to protect him under the LC?
19. The buyer tells his bank: "Don't pay Evelyn, she was late on my last order." Her documents for this LC fully comply. What should the bank do?
20. When a bank checks an LC presentation, what does it examine?

Set 3 of 3

21. The buyer wants proof that the shirts meet the agreed quality. What is the best way under an LC?
22. True or false: a discrepancy in the documents can delay or stop payment under an LC.
23. When might a court stop payment under an LC?
24. Which of these could be a discrepancy?
25. What does the seller mainly gain from an LC?
26. Which of these is NOT a usual LC cost?
27. What is LC margin?
28. In Bangladesh, where does an importer open an LC?
29. How does a usance LC help the buyer?
30. What is Evelyn's back-to-back LC used for?
Found this useful? Pass it on.

Brain feeling full? Take a tea break.