How does an import letter of credit work in international trade transactions?

In a very breif and precise wording,

Letter of credit is mitigating the risk of all parts concern and sharing in the letter of credit i.e. the exporter, the importer, the issuing bank, the confirming bank (if any), as well as the negotiating bank.

The first thing to understand about Letters of Credit is that there are many different variations that have been crafted over the years to meet the requirements of Buyers and Sellers. However, there is a generally accepted format that permeates all Letter of Credit transactions, and that framework will be explained here.The basic purpose of a Letter of Credit is to comfort buyers and sellers in an international trade transaction by essentially replacing the credit of the buyer with the financial backing of the bank that issues the letter of credit. Two basic types of letter of credit are used:1. Commercial Letter of Credit - This is the basic payment document guaranteeing the payment for the goods that are being sold and shipped. Also called a Documentary Letter of Credit.2. Standby Letter of Credit - This is a secondary payment device.

What is an import letter of credit :

Import letter of credit is a payment method in international trade. From now on when we see an import letter of credit term, we must understand that we are looking at the international trade transaction from the eyes of the importers. With the help of the import letter of credit importers pay to their suppliers for the goods they agreed to buy.   

Step by step import letter of credit transaction 

PS : I am the importer of this transaction. I will explain the process from the importer side.

Step 1 : As an importer we need to find ourself a supplier. Then we need to write down our agreement into a sale contract or proforma invoice. Remember letter of credit is not a sales contract. Actually, letter of credit is independent structure from the sale or other contract on which they may be based. Therefore, it should be kept in mind that a good sales contract protects the party, which behaves in goodwill against various kinds of risks. 

Step 2: After we sign the sale contract with our supplier, as an importer (importer is the applicant of the lc transaction) we have to apply to our bank to have the letter of credit issued in favour of our supplier. Letter of credit application must be in accordance with the terms of the sales agreement.

Step 3: At this point issuing bank prepares the letter of credit in swift message format and transmit it to the exporter's bank. ( exporter's bank is called advising bank in lc terminology) 

Step 4: The advising bank advises the letter of credit to the beneficiary without any undertaking to honor or negotiate. The advising bank has two responsibilities against to the beneficiary. Advising bank's first responsibility is satisfy itself as to the apparent authenticity of the credit and its second responsibility is to make sure that the advice accurately reflects the terms and conditions of the credit received.

Step 5: The beneficiary should check the conditions of the credit as soon as it is received from the advising bank. If some disparities have been detected beneficiary should inform the applicant about these points and demand an amendment. If letter of credit conditions seem reasonable to the beneficiary then beneficiary starts producing the goods in order to make the shipment on or before the latest shipment date stated in the L/C. The beneficiary ships the goods in accordance with the terms and conditions stated in the credit.

Step 6:  As soon as the goods are loaded, exporter collects the shipment documents which are requested by the credit and gives them to the advising bank.

Step 7: The advising bank dispatches the documents to the issuing bank on behalf of the beneficiary. 

Step 8:. The issuing bank checks the documents according to terms and conditions of the credit and governing letter of credit rules. If the documents are found to be complying after the examination the issuing bank honors its payment obligation and transmits the payment to the exporter through advising bank. 

Step 9:.On final step issuing bank transmits the documents to the importer. The applicant uses these documents to clear the goods from the customs.