How do banks talk to each other: An Introduction to LCs

Banks need to communicate with each other when there is a transaction that happened on credit, and a LC is provided.

What is a LC? It's a commonly used abbreviation that stands for "Letter of Credit." It is a financial document issued by a bank that guarantees a buyer's payment to a seller will be received on time and for the correct amount. If the buyer is unable to make payment, the bank covers the full or remaining amount. Imagine an Indian textile importer purchasing fabric from a manufacturer in Italy. To ensure the Italian seller gets paid once they ship the goods, the Indian buyer asks their bank to issue an LC. The Italian seller’s bank confirms the LC, ships the goods, submits the documents, and receives payment safely and with the bank acting as a trusted intermediary.

Types of Letters of Credit

1. Revocable / Irrevocable (most LCs today are irrevocable): This gives the power to the purchaser to revoke the LC wherever they want without the seller getting any knowledge about it. 
2. Confirmed LC (adds another bank’s guarantee) 
3. Sight LC (payment on presentation):- Payment is made when the goods are received 
4.  Usance / Term LC (payment after a set time)
5.  Standby LC (used more like a guarantee than a payment mechanism):- A safety net. 
6. Revolving LC used for multiple shipments over a specified period, allowing the buyer to make multiple drawdowns up to a predetermined limit./

Each and every LC should comply with the UCP 600 guidelines. In some ways, it's not legally bound to, but it's highly recommended in business practices because of the safety and clarity it provides in such transactions.
What is UCP 600?

UCP 600 (Uniform Customs and Practice for Documentary Credits) is a globally accepted set of rules established by the International Chamber of Commerce (ICC) to standardize the use of Letters of Credit (LCs) in international trade. It ensures clarity and fairness by defining the roles of the issuing bank, confirming bank, and beneficiary, as well as the requirements for document presentation and the principle of strict compliance, meaning documents must match LC terms exactly. 

However, UCP 600 focuses on legal rules rather than practical guidance. That’s where ISBP (International Standard Banking Practice) comes in. ISBP is not a set of rules, but rather a companion guide to UCP 600 that helps banks and traders understand how to correctly interpret and examine trade documents, thereby reducing the risk of discrepancies. 

Letters of Credit (LCs) play a vital role in building trust and ensuring secure payments in international trade. While the process may seem complex at first, it is built on well-established rules like UCP 600 and supported by secure communication systems like SWIFT and SFMS. These tools help banks coordinate effectively and protect the interests of both buyers and sellers. As global trade continues to grow, understanding how LCs work and how banks "talk" to each other can give businesses a significant edge. Whether you're an importer, exporter, or a student of finance, having a solid grasp of LCs is not just useful; it's essential.