What Is a Letter of Credit and How Does It Work?

A letter of credit is a financial instrument issued by a bank, providing a payment guarantee on behalf of a buyer to a seller. This commitment ensures the seller receives payment for goods or services, provided they fulfill the stipulated terms. Letters of credit are particularly useful in international trade, where parties may not have established relationships or face differing legal environments. They mitigate financial risks in cross-border transactions, offering reliable payment assurance.

How a Letter of Credit Works

The process begins when a buyer (applicant) requests their bank to issue an LC for the seller (beneficiary). This request specifies payment terms, including details about goods, shipping, and required documentation. Once the buyer’s bank (issuing bank) approves, it formally issues the letter of credit.

The issuing bank transmits the LC to the seller’s bank, the advising bank. The advising bank notifies the seller of its terms. The seller reviews the LC to ensure its terms align with the sales contract and can be met. Required documents often include a commercial invoice, a bill of lading or air waybill, a packing list, and a certificate of origin.

After the seller ships goods or provides services, they gather all necessary documents. These are presented to the advising bank within a specific timeframe, before the LC’s expiration. The advising bank examines them to ensure strict compliance with the LC’s terms.

If compliant, the advising bank forwards documents to the issuing bank. The issuing bank verifies them for strict compliance. Once verified, the issuing bank pays the advising bank, which remits funds to the seller. The issuing bank debits the buyer’s account or seeks reimbursement. Fees typically range from 0.1% to 2% of the LC value.

Main Parties Involved

The main parties involved in a letter of credit transaction are:

The applicant: The buyer who initiates the LC request and is responsible for reimbursing the issuing bank.
The beneficiary: The seller who receives payment by presenting documents that strictly conform to the LC’s conditions.
The issuing bank: The buyer’s bank that issues the LC and guarantees payment to the beneficiary upon presentation of compliant documents.
The advising bank: Typically the seller’s bank, which informs the beneficiary of the LC’s existence and authenticates its validity. It acts as an intermediary.
A confirming bank: May add its own guarantee to the LC, providing additional payment security for the beneficiary, especially when the issuing bank’s creditworthiness or political risks are a concern.

Common Types of Letters of Credit

A commercial letter of credit is the most common form, used as the primary payment mechanism for trade transactions. It is a direct undertaking by the issuing bank to pay the beneficiary upon presentation of stipulated documents.

A standby letter of credit (SBLC) functions as a secondary payment mechanism or performance guarantee. An SBLC is drawn upon only if the applicant fails to fulfill a contractual obligation, acting as a financial safety net.

Letters of credit are also categorized by their amendability. A revocable letter of credit can be amended or canceled by the issuing bank without prior consent from the beneficiary. Most letters of credit in international trade are irrevocable, meaning they cannot be modified or canceled without the agreement of all parties. This irrevocability provides the seller with stronger payment assurance.

A confirmed letter of credit involves a second bank, the confirming bank, adding its guarantee to the issuing bank’s commitment. This provides the beneficiary with enhanced security, as they now have two bank guarantees for payment.

Situations Where Letters of Credit Are Used

Letters of credit are frequently employed in international trade, especially when buyers and sellers are in different countries and lack established relationships. Geographic distance, unfamiliar legal systems, and varying commercial practices make LCs a preferred method for managing payment risk. They provide a standardized framework for cross-border transactions.

These financial instruments are also valuable in high-value transactions where financial exposure is substantial. The bank’s guarantee significantly reduces the risk of non-payment for the seller and non-delivery for the buyer. LCs offer a mechanism to proceed securely when new business relationships are formed and trust is not yet fully established.

Letters of credit are often used when dealing with emerging markets or regions experiencing political or economic instability. In such environments, the added security of a bank’s guarantee helps mitigate risks like currency controls, government interference, or economic downturns. Certain industries, such as commodity trading, also rely heavily on LCs due to large transaction volumes and volatile prices.