International trade often brings together buyers and sellers located in different countries. The exporter may worry about shipping goods without receiving payment, while the importer may hesitate to pay before confirming that the shipment has been dispatched as agreed.

A Letter of Credit, commonly known as an LC, helps reduce this payment risk. It is a banking arrangement under which a bank commits to pay the seller after the required documents are submitted and found to comply with the conditions stated in the LC.

Although Letters of Credit are widely used in import-export transactions, they can also be used for certain high-value domestic business deals.

What Is a Letter of Credit?

A Letter of Credit is issued by a bank at the request of a buyer, also called the applicant. Through the LC, the issuing bank promises to pay the seller or beneficiary if the seller presents the specified documents within the prescribed period and satisfies all the stated terms.

This arrangement gives the exporter greater confidence because payment primarily depends on the undertaking of the issuing bank rather than only on the buyer’s willingness to pay.

The importer also receives a degree of protection because the bank will release payment only when documents matching the conditions of the LC are presented.

However, an LC should not be treated as an unconditional guarantee covering every aspect of a trade deal. Banks examine documents; they do not usually inspect the goods themselves or independently confirm their quality. The payment commitment therefore depends on documentary compliance.

How Does a Letter of Credit Work?

The Letter of Credit process usually begins after the buyer and seller finalise a sales agreement.

1. Buyer and seller agree on trade terms

The importer and exporter decide the price, quantity, product specifications, shipping schedule, delivery destination and payment method. They also agree that payment will be made through an LC.

The sales contract should clearly identify the documents the exporter must provide. These could include an invoice, transport document, packing list, certificate of origin or insurance document.

2. Buyer requests an LC from the bank

The importer asks its bank to issue a Letter of Credit in favour of the exporter. Before approving the request, the bank may evaluate the buyer’s credit profile, banking history and ability to meet the payment obligation.

The bank may require cash margin, collateral or an approved credit limit. Charges can also apply for issuing, amending and processing the LC.

3. Issuing bank sends the LC

After approval, the buyer’s bank issues the LC and sends it through a banking channel to a bank in the exporter’s country. This second bank is generally known as the advising bank.

The advising bank checks the apparent authenticity of the LC and communicates its terms to the exporter. Advising the LC does not automatically mean that this bank has added its own payment guarantee.

4. Exporter reviews the conditions

The seller must carefully review the LC before manufacturing or dispatching the goods. Names, dates, amounts, product descriptions, ports and document requirements must be practical and consistent with the sales agreement.

If a condition is incorrect or impossible to fulfil, the exporter should request an amendment before shipping. Ignoring an error at this stage may create a documentary discrepancy later.

5. Goods are dispatched

Once satisfied with the conditions, the exporter ships the goods within the permitted period. The seller then collects the documents required under the Letter of Credit and submits them to the nominated or advising bank.

6. Banks examine the documents

The documents are checked against the conditions written in the LC. If the presentation complies, they are forwarded to the issuing bank for payment or acceptance, depending on the type of credit.

If a discrepancy is found, payment may be delayed or refused unless the buyer agrees to waive it. Even a minor inconsistency involving dates, spellings, quantities or document descriptions can cause complications.

7. Payment is completed

When the presentation is accepted, the exporter receives payment according to the LC terms. The importer can then obtain the relevant documents needed to claim the goods from the carrier.

Official trade guidance describes an LC as a bank’s commitment to pay an exporter when the specified documentary requirements are fulfilled. More details are available in the International Trade Administration’s Letter of Credit guide.

Who Takes Part in an LC Transaction?

A typical Letter of Credit may involve the following parties:

• Applicant: The buyer or importer requesting the LC
• Beneficiary: The seller or exporter entitled to receive payment
• Issuing bank: The importer’s bank that issues the payment undertaking
• Advising bank: The bank that authenticates and communicates the LC to the exporter
• Confirming bank: A bank that adds its own payment undertaking when confirmation is requested and approved
• Nominated bank: The institution authorised to receive documents, negotiate them or make payment under the LC

Not every transaction includes a confirming or separate nominated bank. The structure depends on the countries, banks and commercial terms involved.

Common Types of Letters of Credit

Sight Letter of Credit

Under a sight LC, payment is made after compliant documents are presented and examined. “Sight” does not always mean immediate payment on the same day, as banks still need time to review and process the documents.

Usance or Deferred-Payment LC

A usance LC allows payment after a specified credit period, such as 30, 60 or 90 days. The agreed period may begin from the shipment date, invoice date or another event specified in the credit.

Confirmed Letter of Credit

In a confirmed LC, another bank adds its own payment commitment to that of the issuing bank. Exporters may request confirmation when they are concerned about the issuing bank, political conditions, currency restrictions or country risk.

Confirmation offers additional protection but normally involves extra charges.

Irrevocable Letter of Credit

An irrevocable LC cannot ordinarily be cancelled or changed unilaterally after issuance. Amendments generally require the agreement of the affected parties.

Many documentary credits used in international trade operate under internationally recognised rules such as the Uniform Customs and Practice for Documentary Credits. The Reserve Bank of India also refers to the UCP framework in its guidance concerning trade documentation.

Transferable Letter of Credit

A transferable LC allows the original beneficiary to transfer all or part of the available credit to another beneficiary, provided the credit expressly states that it is transferable. It may be useful when an intermediary arranges a transaction between a supplier and an overseas buyer.

Standby Letter of Credit

A standby LC generally works as a backup payment mechanism. It may be invoked if the applicant fails to perform a payment or contractual obligation, subject to the documents and conditions stated in the instrument.

Benefits for Importers and Exporters

For exporters, an LC can reduce dependence on the buyer’s direct promise to pay. It can be particularly useful when dealing with a new customer, an unfamiliar overseas market or a high-value order.

For importers, the arrangement ensures that payment is linked to the presentation of specified shipping and commercial documents. An LC may also help the buyer negotiate credit terms instead of paying the entire amount in advance.

The banking trail created by an LC can also improve transparency and help both parties manage their trade records.

Costs and Risks Businesses Must Consider

Letters of Credit are secure but can be expensive and administratively demanding. Charges may include issuance fees, advising fees, confirmation charges, amendment costs, document-handling fees and discrepancy charges.

Document errors are among the most common risks. A mismatch between the LC and the invoice, transport document or shipment date may hold up payment.

Businesses must also remember that documentary compliance does not prove that the goods are defect-free. Product quality, inspection standards, dispute resolution and insurance should be addressed separately in the sales contract.

Final Takeaway

A Letter of Credit can make international trade safer by replacing a simple promise between buyer and seller with a conditional payment undertaking from a bank. The exporter must ship according to the agreement and submit compliant documents, while the importer must arrange sufficient credit or funds with the issuing bank.

Before using an LC, both parties should review its wording, fees, deadlines and documentary conditions with experienced banking and trade professionals. A carefully drafted LC can reduce payment uncertainty, but an impractical condition or small documentation error can delay the entire transaction.