Letter of Credit (LC) — Definition, Mechanism, and Practical Guide
What is a Letter of Credit (LC)?
A Letter of Credit (LC) is a written commitment issued by a bank at the request of a buyer (applicant), guaranteeing the seller (beneficiary) payment of a specified amount upon presentation of agreed-upon documents. Payment is based on documentary compliance, not the actual inspection of goods.
Note: Banks rely on documents, not the quality or contents of goods; precise compliance with LC terms is essential.
Parties Involved
- Applicant: Buyer or importer requesting the LC.
- Beneficiary: Seller or exporter entitled to receive payment.
- Issuing Bank: Bank in the buyer’s country that issues the LC.
- Advising/Confirming Bank: Bank in the seller’s country that advises or confirms payment.
How LC Works — Step by Step
- Buyer and seller agree on trade terms (price, goods, documents, and timeline).
- Buyer requests LC issuance from their bank.
- Issuing bank issues LC and notifies the advising bank.
- Seller prepares, packs, and ships goods; prepares required documents.
- Seller submits documents to the advising bank; banks check compliance.
- If documents match, payment is made, and documents are sent to the buyer for customs clearance.
Example: An importer requests a $100,000 LC for machinery; the bank guarantees payment upon receiving compliant invoice, bill of lading, and certificate of origin.
Common Types of LC
| Type |
Features / Use |
| Irrevocable |
Changes require consent of all parties; most common. |
| Sight |
Payment upon presentation of compliant documents. |
| Usance / Deferred |
Payment after a specified period (e.g., 30 or 90 days). |
| Confirmed |
Confirming bank also guarantees payment; used for higher-risk countries. |
| Transferable |
Can transfer all or part to a secondary beneficiary; suitable for intermediaries. |
| Back-to-Back |
Used for chain transactions through intermediaries. |
| Standby |
Functions like a guarantee; pays if obligations are not met. |
Key Documents
- Commercial Invoice
- Bill of Lading or Airway Bill
- Certificate of Origin
- Packing List
- Insurance Certificate
- Inspection Certificate (if required)
Note: Banks check only document compliance; even minor discrepancies can delay or block payment.
Advantages
For Sellers:
- Guaranteed payment by a reputable bank
- Reduced counterparty risk
- Can use LC for financing or discounting
For Buyers:
- Payment only upon document compliance
- Cash flow management with deferred LC
- Builds seller trust and eases negotiations
Risks and Common Issues
- Document discrepancies (major cause of delays)
- Bank fees (issuance, advising, confirmation, discounting)
- Country or bank risk (bank insolvency, political restrictions)
- Currency risk (exchange rate fluctuations between issuance and payment)
Best Practices
- Review LC documents before shipping; correct discrepancies.
- For high-risk countries/banks, request a confirmed LC.
- Use discounting or partial prepayment to reduce liquidity risk.
- Follow UCP 600 guidelines and seek banking/legal advice.
- Set accurate shipment and document dates to avoid LC expiration.
- For amendments, follow a formal written process through banks.
FAQ
- Does LC guarantee product quality?
No. LC guarantees payment based on documents; quality is outside the bank’s scope unless inspection certificates are required.
- What are LC costs?
Includes issuance, advising, confirmation, discounting, and intermediary fees; varies by amount, country, bank, and document complexity.
- How to avoid document discrepancies?
Prepare sample documents before LC issuance, use checklists, and coordinate with banking experts.
LCs are essential tools in international trade, ensuring secure payment, reducing risk, and enabling smoother cross-border transactions.
