Letter of Credit

Letter of Credit — Definition, Types, and Uses

A letter of credit (LC) is a bank-issued guarantee that a seller will receive payment from a buyer on time and for the agreed amount. It shifts payment risk from the seller to the issuing bank, which pays the seller when the LC’s conditions are met. Letters of credit are widely used in international trade to bridge legal, commercial, and distance-related risks between parties.

Key takeaways

• An LC guarantees payment by a bank if the buyer cannot pay.
• Common types: commercial, standby, revolving, confirmed, traveler’s, and red-clause.
• Banks require collateral or creditworthiness and charge fees (often a percentage of the LC amount).
• LCs are governed in international trade by standards such as the ICC’s Uniform Customs and Practice for Documentary Credits (UCP).

How a Letter of Credit works

1. Buyer and seller agree on a sales contract with LC payment terms.
2. Buyer requests an LC from their bank (the issuing bank) and provides required collateral or credit support.
3. The issuing bank issues the LC and sends it to the seller’s bank (advising or confirming bank).
4. The seller ships goods and presents the required documents (e.g., bill of lading, invoice) to their bank.
5. If documents comply with the LC terms, the seller’s bank forwards them to the issuing bank and payment is made.
6. The issuing bank seeks reimbursement from the buyer according to the underlying agreement.

Important notes:
* The bank’s obligation is documentary—payment depends on presentation of the specified documents, not on the underlying contract performance.
* LCs may be transferable (allowing the beneficiary to assign payment rights).
* Confirmed LCs add a second bank’s guarantee, reducing beneficiary exposure to the issuing bank or country risk.

Common types of letters of credit

• Commercial (sight) LC — Issuing bank pays the seller directly when documentary conditions are met.
• Standby LC — Functions like an insurance policy: the bank pays only if the buyer fails to perform or pay.
• Revolving LC — Allows multiple draws up to a limit over a set period; useful for ongoing shipments.
• Confirmed LC — A second (confirming) bank guarantees payment in addition to the issuer.
• Traveler’s LC — Guarantees payment for travelers’ drafts at foreign banks (less common today).
• Red-clause LC — Provides advance payments to the seller before shipment (higher risk for the bank).

Costs and requirements

• Fees vary by bank, transaction size, LC type, and country risk; common charges are a percentage of the LC amount (e.g., 0.5–1% or more).
• Confirmed LCs typically cost more due to the additional guarantee.
• Banks generally require collateral, cash, or a credit line before issuing an LC.
• Processing times and documentation requirements can increase transaction costs.

How to apply (typical import-export flow)

1. Negotiate contract terms and confirm LC payment is acceptable.
2. Buyer applies to their bank for an LC, supplying the sales contract and collateral.
3. Issuing bank drafts and issues the LC to the seller’s bank.
4. Seller reviews the LC, ships goods according to its terms, and presents required documents.
5. Seller’s bank checks documents; if compliant, it forwards them to the issuing bank and payment follows.
6. Buyer’s bank debits the buyer or calls on collateral to settle the LC.

Pros and cons

Pros:
* Provides payment assurance for sellers and credit support for buyers.
* Reduces commercial and country risk in international trade.
* Can be tailored to specific transactions and terms.
Cons:
* Costs are typically borne by the buyer.
* Strict documentary compliance can lead to payment delays or disputes.
* Setup and administration can be time-consuming.
* May not protect against all political or economic changes.

Real-world application

Large banks often issue or confirm LCs for clients in regions with higher country or commercial risk. For exporters in unstable economies, a confirmed LC from a reputable international bank reduces the chance of nonpayment.

Frequently asked questions

Q: When does payment occur under an LC?
A: Payment occurs when the beneficiary presents documents that fully comply with the LC’s terms; it is a documentary, not performance-based, obligation.

Q: What’s the difference between commercial and revolving LCs?
A: A commercial LC funds a single transaction upon document compliance. A revolving LC allows multiple draws up to a limit over a set period for repeated shipments.

Q: What do banks require to issue an LC?
A: Banks typically require evidence of creditworthiness, collateral, or a cash deposit and assess country and commercial risk before issuing an LC.

Bottom line

Letters of credit are powerful tools for managing payment risk in trade, especially across borders. They provide security for sellers and financing flexibility for buyers, but involve fees, strict documentary rules, and administrative effort. Start with your bank to explore LC options and consider a confirming bank when additional assurance is needed.