What Is a Letter of Credit?

International trade allows businesses to buy and sell goods across borders, opening up opportunities to reach new markets and source products from around the world. However, trading internationally also involves risks. Buyers may worry that the seller will not deliver the goods as promised, while sellers may fear they will not receive payment after shipping the products. One of the most widely used financial instruments to reduce these risks is the letter of credit (LC).

A letter of credit provides assurance to both buyers and sellers by involving a trusted financial institution that guarantees payment under agreed conditions. Understanding how letters of credit work can help businesses trade with greater confidence.

What Is a Letter of Credit?

A letter of credit is a document issued by a bank on behalf of a buyer that guarantees payment to a seller, provided the seller meets the terms and conditions specified in the agreement.

In simple terms, the buyer's bank promises to pay the seller once the seller provides documents proving that the goods have been shipped or the agreed services have been performed. This reduces the financial risk for both parties.

Letters of credit are commonly used in international trade, especially when the buyer and seller have not worked together before or operate in different countries with different legal systems.

How Does a Letter of Credit Work?

The process typically follows these steps:

1. The buyer and seller sign a sales contract.

2. The buyer requests a letter of credit from their bank.

3. The issuing bank sends the letter of credit to the seller's bank.

4. The seller reviews the terms and ships the goods.

5. The seller submits the required shipping and trade documents to their bank.

6. The documents are checked for compliance with the letter of credit.

7. If all conditions are met, payment is made to the seller.

8. The buyer receives the documents needed to claim the goods.

The bank does not evaluate the quality of the goods—it only verifies that the required documents match the terms of the letter of credit.

Parties Involved

Several parties usually participate in a letter of credit transaction:

• Applicant: The buyer requesting the letter of credit.

• Beneficiary: The seller who will receive payment.

• Issuing bank: The buyer's bank that issues the letter of credit.

• Advising bank: The seller's bank that authenticates and forwards the letter of credit.

• Confirming bank (if applicable): A bank that adds its own payment guarantee in addition to the issuing bank's guarantee.

Each participant plays a role in ensuring the transaction proceeds smoothly.

Documents Commonly Required

Payment under a letter of credit depends on the submission of specific documents, which may include:

• Commercial invoice

• Bill of lading

• Packing list

• Insurance certificate

• Certificate of origin

• Inspection certificate

• Air waybill (for air shipments)

The exact documents required depend on the terms agreed by the buyer and seller.

Types of Letters of Credit

There are several types of letters of credit designed for different business situations.

Revocable Letter of Credit

This type can be changed or canceled by the issuing bank without notifying the seller. Because it offers limited protection, it is rarely used today.

Irrevocable Letter of Credit

An irrevocable letter of credit cannot be amended or canceled without the agreement of all parties. It is the most common type used in international trade.

Confirmed Letter of Credit

A confirmed letter of credit includes an additional guarantee from another bank, often located in the seller's country. This provides extra security if the seller has concerns about the issuing bank or the buyer's country.

Sight Letter of Credit

Payment is made shortly after compliant documents are presented and verified.

Usance (Time) Letter of Credit

Payment is made at a future agreed date, such as 30, 60, or 90 days after shipment or document acceptance.

Transferable Letter of Credit

This allows the original beneficiary to transfer part or all of the payment rights to another party, such as a supplier.

Standby Letter of Credit

A standby letter of credit acts as a financial guarantee. It is only used if the buyer fails to fulfill payment or contractual obligations.

Advantages of Letters of Credit

Letters of credit offer numerous benefits to both buyers and sellers.

Benefits for Sellers

• Guaranteed payment if terms are met.

• Reduced risk of buyer default.

• Improved cash flow.

• Increased confidence when dealing with new customers.

• Easier access to financing.

Benefits for Buyers

• Payment occurs only after required documents are presented.

• Greater assurance that shipment has occurred.

• Increased credibility with international suppliers.

• Better control over transaction terms.

Disadvantages of Letters of Credit

Despite their advantages, letters of credit also have drawbacks.

Cost

Banks charge fees for issuing, confirming, advising, and processing letters of credit. These costs can be significant for smaller transactions.

Complex Documentation

The documentation requirements are strict. Even minor errors, known as discrepancies, can delay payment or result in rejection.

Processing Time

Preparing, reviewing, and verifying documents may take several days or weeks.

Limited Protection

Banks examine documents rather than goods. Even if documents comply, the actual goods may not match expectations.

Common Reasons for Document Discrepancies

A seller may experience payment delays if documents contain errors such as:

• Incorrect shipment dates.

• Differences in product descriptions.

• Missing signatures.

• Incorrect invoice amounts.

• Expired letter of credit.

• Missing required documents.

Careful document preparation is essential to avoid these problems.

Letter of Credit vs. Bank Guarantee

Although both involve banks providing financial security, they serve different purposes.

A letter of credit is primarily a payment mechanism used in trade transactions. The bank pays once the seller submits compliant documents.

A bank guarantee serves as a backup promise. The bank only pays if the buyer fails to meet their contractual obligations.

In other words, a letter of credit facilitates payment, while a bank guarantee provides protection against default.

When Is a Letter of Credit Used?

Letters of credit are commonly used when:

• Trading internationally.

• Conducting large-value transactions.

• Working with new suppliers or customers.

• Buying goods from countries with higher political or economic risks.

• Financing imports and exports.

• Building trust between unfamiliar trading partners.

Many industries—including manufacturing, agriculture, machinery, electronics, and commodities—regularly rely on letters of credit.

Best Practices for Businesses

To maximize the benefits of a letter of credit:

• Clearly define contract terms before requesting the letter of credit.

• Carefully review every condition in the document.

• Ensure all shipping documents are accurate and complete.

• Meet shipment deadlines.

• Work with experienced freight forwarders and banks.

• Resolve discrepancies immediately if they arise.

Proper planning can significantly reduce delays and payment issues.

Conclusion

A letter of credit is one of the most trusted payment methods in international trade because it reduces risk for both buyers and sellers. By providing a bank-backed payment guarantee based on compliant documentation, it helps businesses conduct cross-border transactions with greater confidence.

Although letters of credit involve costs and strict documentation requirements, they remain an essential tool for facilitating global commerce. Businesses that understand how they work—and prepare documents carefully—can improve payment security, strengthen trading relationships, and expand into international markets with greater peace of mind.