What Is a Letter of Credit?
A letter of credit is a bank guarantee that ensures a seller gets paid once they meet agreed conditions. Used widely in international trade.
Key Takeaways
- A letter of credit (LC) is a bank's promise to pay a seller when documents proving shipment are presented
- It protects both buyer (goods before payment) and seller (payment guaranteed by bank)
- Documentary compliance is critical — even minor discrepancies can block payment
- LCs are expensive and complex — used for large transactions with new or unknown counterparties
What a letter of credit is
A letter of credit is a written commitment from a buyer's bank to pay a seller a specified amount, provided the seller presents documents that comply exactly with the terms of the credit within a specified timeframe. It substitutes the creditworthiness of the buyer with the creditworthiness of the bank.
How the process works
The buyer instructs their bank (issuing bank) to open an LC in favour of the seller. The issuing bank sends the LC to the seller's bank (advising or confirming bank). The seller ships the goods and assembles required documents — commercial invoice, bill of lading, packing list, certificate of origin, insurance certificate. The seller presents these to their bank, which forwards them to the issuing bank. If documents comply, the issuing bank pays.
Documentary compliance
The bank pays against documents, not against goods. If the bill of lading shows a port of loading slightly different from the LC specification, or if the invoice description does not exactly match the LC wording, the bank will issue a discrepancy notice and payment may be withheld. Studies find that more than 50% of first-presentation LC documents contain discrepancies.
Types of LC
A sight LC pays upon presentation of complying documents. A usance LC pays at a set number of days after presentation — giving the buyer time to sell goods before paying. A confirmed LC means the seller's bank adds its own guarantee. A standby LC is similar to a bank guarantee, used as a backstop payment mechanism.
When to use an LC
LCs cost 0.5% to 2% of transaction value and are operationally complex. They make sense for large transactions with new or unknown counterparties, transactions involving countries with banking instability, and where open account trading is not acceptable. For established relationships with trusted suppliers, open account or advance payment are simpler and cheaper.