Understanding the Concept of a Letter of Credit (LC)
A Letter of Credit (LC) is a financial document issued by a bank guaranteeing that a seller (exporter) will receive payment from a buyer (importer) as long as certain delivery and documentation conditions are met. It acts as a secure payment mechanism in international trade, where business partners are separated by distance, legal systems, and differing business norms.
An LC essentially replaces the buyer’s creditworthiness with that of a bank, creating trust between trading parties. When the exporter ships goods and presents compliant documents, the issuing bank ensures payment—regardless of the buyer’s financial situation.
This system of documentary credit is governed by international rules like UCP 600 (Uniform Customs and Practice for Documentary Credits), issued by the International Chamber of Commerce (ICC).
By using a Letter of Credit, importers protect themselves from non-delivery, while exporters safeguard against non-payment.
The Role of Banks in a Letter of Credit Transaction
Banks are central to every LC transaction. Four major parties typically participate:
- Applicant (Importer/Buyer) – Requests the LC from their bank.
- Issuing Bank – The buyer’s bank that issues the LC.
- Beneficiary (Exporter/Seller) – The party entitled to payment under the LC.
- Advising/Confirming Bank – The seller’s bank that authenticates and sometimes guarantees payment.
When documents comply with the LC terms, the issuing bank or confirming bank releases payment to the exporter. This structure ensures that even if the buyer defaults, the seller still gets paid.
Types of Letters of Credit Used in International Trade
Revocable vs. Irrevocable Letter of Credit
- Revocable LC: Can be modified or canceled by the issuing bank without the beneficiary’s consent. Rarely used today due to high risk.
- Irrevocable LC: Cannot be changed without mutual agreement. Provides stronger protection and is the standard in modern trade.
Confirmed and Unconfirmed Letter of Credit
- Confirmed LC: A second bank (usually in the exporter’s country) guarantees payment in addition to the issuing bank.
- Unconfirmed LC: Only the issuing bank is liable. Used when both parties trust each other or the bank is reputable.
Sight and Usance (Deferred Payment) LC
- Sight LC: Payment made immediately upon presentation of compliant documents.
- Usance LC: Payment deferred to a future date (e.g., 30 or 60 days after shipment).
Standby Letter of Credit (SBLC)
SBLCs function as a guarantee of performance or payment rather than a regular trade payment tool. If the buyer fails to pay or perform, the SBLC ensures compensation to the seller.
Step-by-Step Process of Using a Letter of Credit
Step 1 – Sales Agreement and LC Application
The importer and exporter agree on terms, including LC payment, in the sales contract. The buyer applies to their bank for LC issuance.
Step 2 – Issuance of the LC by Buyer’s Bank
The issuing bank prepares the LC with all specified conditions—product details, shipping terms, deadlines, and required documents—and sends it to the seller’s bank.
Step 3 – Advising and Confirmation by Seller’s Bank
The advising bank authenticates the LC and may confirm it (adding its guarantee). The exporter reviews all terms to ensure compliance before shipping.
Step 4 – Shipment and Document Submission
The exporter ships goods, prepares documents (like invoice, bill of lading, etc.), and submits them to the advising bank. The bank checks documents for accuracy.
Step 5 – Payment and Settlement
If documents meet LC terms, the issuing bank releases payment to the exporter. The buyer receives documents to claim goods.
Essential Documents Required in a Letter of Credit
| Document Type | Purpose |
| Commercial Invoice | Specifies goods, price, and payment details. |
| Bill of Lading (B/L) | Proof of shipment issued by the carrier. |
| Packing List | Details packaging and quantity of goods. |
| Certificate of Origin | Identifies where goods were produced. |
| Insurance Certificate | Proof that goods are insured during transit. |
| Inspection Certificate | Confirms product quality or compliance. |
Accuracy in these documents is crucial—any mismatch can lead to non-payment or delay.
Advantages of Using a Letter of Credit in Trade
Security and Risk Reduction
For exporters, an LC ensures payment upon compliance, while importers pay only when goods are shipped and verified. This mutual assurance encourages global business even between unfamiliar parties.
Global Acceptance and Flexibility
LCs are recognized worldwide, making them a trusted instrument in cross-border trade. They also support various trade terms (FOB, CIF, CFR) and currencies.
Common Risks and Challenges with Letters of Credit
Document Discrepancies
Minor inconsistencies—like spelling errors, date mismatches, or missing clauses—can cause LC rejection. Over 70% of LC presentations initially contain discrepancies.
Cost and Time Considerations
Banks charge fees for issuance, confirmation, and amendments. LC transactions also involve paperwork and inspection delays.
Currency and Political Risks
Exchange rate fluctuations or political instability can affect LC settlements, especially for long-term usance LCs.
How to Mitigate LC-Related Risks
- Partner with reliable banks experienced in trade finance.
- Double-check all documents before submission.
- Seek legal counsel for complex international contracts.
- Use digital LC platforms to minimize human error.
Real-Life Example of a Letter of Credit Transaction
An exporter in India sells $100,000 worth of textiles to a retailer in France. The French buyer opens an irrevocable LC with BNP Paribas, confirmed by State Bank of India. Once the Indian exporter ships goods and submits compliant documents, payment is released instantly. Both parties trade securely without direct financial risk.
Letter of Credit vs. Bank Guarantee
| Aspect | Letter of Credit (LC) | Bank Guarantee (BG) |
| Purpose | Payment mechanism | Performance assurance |
| Trigger | When documents comply | When default occurs |
| Used By | Importers/Exporters | Contractors/Suppliers |
| Payment Risk | Lower | Higher |
| Common In | Trade finance | Project finance |
Expert Tips for Businesses Using LC for the First Time
- Always review LC terms before shipment.
- Use irrevocable and confirmed LC for high-value trade.
- Keep clear communication between importer, exporter, and banks.
- Maintain compliance with UCP 600 rules.
- Digitize your trade documents for faster processing.
Future Trends: Digital Letters of Credit and Blockchain Technology
Digitalization and blockchain-based LCs are transforming global trade. Platforms like Contour and Marco Polo allow real-time document exchange, reducing fraud and paperwork. By 2030, experts predict that over 60% of global trade finance operations will be fully digital.
Frequently Asked Questions (FAQs)
Q1: What is the main purpose of a Letter of Credit in trade?
A Letter of Credit ensures secure payment between importer and exporter by involving trusted banks.
Q2: Is an LC mandatory for international trade?
No, but it’s highly recommended for first-time or high-risk transactions.
Q3: How long does LC payment take?
Typically within 3–10 business days after document submission, depending on LC type.
Q4: Can an LC be canceled or amended?
Only with the consent of all parties if it’s irrevocable; revocable LCs can be altered unilaterally.
Q5: What are UCP 600 rules?
They’re international guidelines that standardize LC procedures globally.
Q6: Is a Letter of Credit the same as a bank guarantee?
No, an LC ensures payment, while a bank guarantee compensates only if a party defaults.
Conclusion
A Letter of Credit remains one of the most reliable tools for safe international trade. By understanding its types, process, and documentation, both importers and exporters can trade confidently across borders. Whether you’re a small business or a large corporation, mastering the use of LC ensures financial security, global credibility, and seamless transactions.
