What is a Letter of Credit (LC)?

pdolhii
4 days ago
5 min read

This article provides a clear explanation of letters of credit in simple terms.

Understanding Letters of Credit

What is a letter of credit from a bank?

If you’re wondering what is the meaning of letter of credit, it’s a financial guarantee from a bank. A letter of credit (LC) is a bank’s written undertaking to pay the seller upon presentation of documents that comply with the LC terms. In simple terms, it’s a secure method of payment used in global trade. This shifts the risk from the buyer to the bank and helps build trust between trading partners.

Why letters of credit are used in trade

Businesses use letters of credit to make international trade safer and more reliable. The buyer doesn’t have to send money right away. Instead, the bank pays the seller only after the goods are shipped and all the documents are checked out.

For the seller, it’s a huge relief – even if the buyer disappears or goes bankrupt, the bank still guarantees payment as long as the terms are met. Large international banks often confirm LCs issued by local banks in developing markets, giving exporters additional assurance of payment.

How a Letter of Credit Works

Step-by-step process of LC

You might ask, how does a letter of credit work? After signing a contract, the buyer asks their bank to issue an LC for the seller. The bank prepares and sends it to the seller’s advising bank, which verifies it and informs the seller.

Once the LC is received and, if applicable, confirmed by the seller’s bank, the seller ships the goods and submits the required documents. The negotiating or confirming bank reviews the documents for compliance and forwards them to the issuing bank.

If everything matches, the issuing bank releases payment to the negotiating or confirming bank, which then credits the seller’s account. The buyer uses the shipping documents to claim the goods and subsequently reimburses the issuing bank.

Parties involved in a letter of credit

Applicant (Buyer): Requests the LC and funds the payment.
Beneficiary (Seller): Receives payment after meeting LC terms.
Issuing Bank: Issues the LC and guarantees payment upon presentation of complying documents.
Advising Bank: Usually the seller’s bank; authenticates and forwards the LC to the beneficiary without assuming payment responsibility.
Confirming Bank (optional): Adds its own payment guarantee in case the issuing bank fails, often used in international trade for extra security.

Benefits and protections for buyers and sellers

A letter of credit protects both sides. The seller knows payment is secured by the bank, while the buyer’s money stays untouched until the shipment is verified.

Each side can rely on a clear, transparent process instead of relying on personal trust.”. The bank handles the paperwork and timing, which removes guesswork and builds confidence. It also keeps cash flowing: buyers don’t have to pay until the goods are on their way, and sellers can use a confirmed LC to access financing while waiting for payment.

Types of Letters of Credit

Commercial vs. standby LC

A Documentary (or Commercial) Letter of Credit is the standard form used in trade transactions. Basically, the buyer’s bank pays the seller once all the shipping documents are checked out. It's like the bank stepping in to make sure the seller gets paid.

A Standby Letter of Credit acts as a secondary guarantee and is drawn upon only if the buyer fails to fulfill payment or performance obligations.

Revocable and irrevocable LC

A Revocable Letter of Credit can be altered or canceled before payment, but such credits are virtually obsolete in modern trade due to lack of security for exporters.

An Irrevocable Letter of Credit, on the other hand, can’t be changed or canceled unless all parties agree. According to the ICC’s UCP 600 rules, every LC is considered irrevocable by default, ensuring stronger protection for both sides.

Examples of letters of credit in practice

Here are a few examples of letters of credit in practice. If an exporter sells to a buyer in a high-risk market, the buyer’s bank can issue a letter of credit guaranteeing payment once all contract terms are met. This gives the exporter security even if the buyer later defaults.

In more complex deals, a “back-to-back” LC can be used for instance, an exporter may use a buyer’s LC as collateral for their own bank to issue a smaller LC to a supplier.

Small businesses also rely on irrevocable LCs when importing goods or equipment, ensuring they only pay once shipment is confirmed and documents are verified.

Costs and Considerations

Letter of credit fees

Many people ask about the cost of a letter of credit. The issuing bank typically takes an issuance fee of about 0.5%–1% of the LC amount (on average around 0.75%). If a confirming bank is involved, there’s also a confirmation fee, which is usually higher. Other possible costs include advising fees, document handling or negotiation fees, and amendment fees for any changes made after issuance. These charges vary depending on the banks, countries, and the risk level of the deal.

Risks associated with LC

LCs reduce risk but don’t remove it. Banks check documents, not goods, so discrepancies in paperwork can delay or prevent payment.

Fraud, currency fluctuations, and political instability can also cause problems, though confirmation by a reliable bank helps.

An LC guarantees payment for compliant documents, not product quality disputes over goods that must be settled separately.

Choosing the right LC for your business

The right LC depends on your transaction. For a single shipment, a standard sight LC is usually enough. For ongoing trade, a revolving LC streamlines multiple payments under one agreement. When you need a performance guarantee, choose a standby LC.

If the buyer’s bank or country seems risky, ask the seller’s bank to confirm the LC for extra security.

Work with a bank experienced in trade finance. A specialist can help structure the LC type and terms to fit your deal and minimize risk.

FAQ on Letters of Credit