What Is a Letter of Credit?
A Letter of Credit (L/C) is a financial instrument issued by a bank (the issuing bank) on behalf of a buyer (the applicant), guaranteeing that a seller (the beneficiary) will receive payment — provided the seller presents documents that comply exactly with the terms specified in the L/C. It's effectively the bank substituting its creditworthiness for that of the buyer.
Letters of credit are governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce — a globally recognized set of rules that most banks worldwide follow.
Why Letters of Credit Matter in International Trade
In a domestic sale, a seller can relatively easily take legal action against a non-paying buyer. Internationally, that becomes complicated by distance, jurisdictional differences, language barriers, and enforcement challenges. The L/C solves this by moving trust from the counterparty to a bank:
- For the exporter (seller): Payment is guaranteed by the bank, not just the buyer's word
- For the importer (buyer): Payment is only released when documentary proof of shipment and compliance is provided
- For both parties: Reduces the need for advance payment or open-account risk
How a Letter of Credit Works: Step by Step
- Sales contract agreed: Buyer and seller agree to use an L/C as the payment method and outline the terms.
- Buyer applies to their bank: The buyer's bank (issuing bank) reviews the buyer's creditworthiness and issues the L/C to the seller.
- L/C advised to seller: The issuing bank sends the L/C to a bank in the seller's country (the advising bank), which forwards it to the seller.
- Seller reviews and ships: The seller reviews the L/C terms, makes any necessary amendments, ships the goods, and collects the required documents.
- Documents presented: The seller submits a compliant document set to the advising/nominated bank within the L/C's validity and presentation periods.
- Documents examined: The bank checks documents for strict compliance with the L/C terms (typically within 5 banking days).
- Payment released: If documents comply, the issuing bank pays the seller (or the nominated bank does, and is reimbursed by the issuing bank).
- Buyer receives documents: The buyer uses the shipping documents (especially the Bill of Lading) to collect the goods at the destination port.
Types of Letters of Credit
| Type | Description |
|---|---|
| Irrevocable L/C | Cannot be modified or cancelled without consent of all parties. The standard for trade. |
| Confirmed L/C | A second bank (in the seller's country) adds its own payment guarantee. Useful when the issuing bank's country carries political or economic risk. |
| Sight L/C | Payment is made immediately upon presentation of compliant documents. |
| Usance (Deferred) L/C | Payment is made at a fixed period after presentation (e.g., 60 or 90 days). Gives the buyer time to sell goods before paying. |
| Transferable L/C | The beneficiary can transfer part or all of the credit to a third party — useful for intermediaries. |
| Standby L/C | Functions more like a bank guarantee — only drawn upon if the applicant defaults. Common in US trade. |
The Critical Importance of Document Compliance
The biggest risk for exporters using an L/C is documentary discrepancy. Banks operate on documents alone — they do not inspect goods or verify underlying commercial reality. A single discrepancy (a misspelled port name, a missing endorsement, a date outside the allowed window) can result in the bank refusing to pay until the discrepancy is accepted by the buyer.
Common discrepancies include:
- Bill of lading not marked as "on board" or missing required notify party
- Commercial invoice description not matching the L/C exactly
- Late presentation of documents after the allowed period
- Goods shipped before or after the L/C's shipment date window
- Partial shipment made when the L/C prohibits it
When to Use a Letter of Credit
An L/C makes most sense when:
- You're dealing with a new buyer in an unfamiliar market for the first time
- The buyer's country has political instability or foreign exchange controls
- The transaction value is high and the risk of non-payment would be significant
- The buyer requires an L/C as their standard procurement policy
L/Cs are less suitable for small, frequent, or low-value transactions where the bank fees (typically 0.5%–2% of the transaction value) would erode margins. For established trading relationships, open account or documentary collections are often more practical.
Practical Tips for Exporters
- Review the L/C immediately upon receipt — request amendments before shipping, not after
- Ensure your freight forwarder and document preparer are familiar with L/C requirements
- If your buyer's country is high-risk, insist on a confirmed L/C
- Keep meticulous records of all documents and submission dates