Introduction to Letters of Credit
International trade often brings together businesses that have never met, operate under different legal systems, and are separated by thousands of miles. Because of this, trust alone is rarely enough to keep transactions moving smoothly. A widely used solution to bridge this gap is the letter of credit, a financial tool that allows both buyer and seller to proceed with confidence. This arrangement places the bank in a pivotal role, acting as a guarantor that payment will be made once agreed-upon conditions are satisfied. For global commerce, where misunderstandings or nonpayment can disrupt supply chains, letters of credit offer structure, reliability, and risk reduction.
Essentially, a letter of credit reassures the seller that they will receive their money even if the buyer is unable to fulfill the payment. At the same time, the buyer gains assurance that funds will only be released when the seller provides documents proving they have met their obligations. This balance is what makes letters of credit one of the most trusted mechanisms for cross-border transactions.
What a Letter of Credit Really Is
A letter of credit, often shortened to LC, is a promise issued by a financial institution that guarantees the buyer’s payment to the seller. Instead of relying solely on the buyer’s ability to pay, the seller receives the bank’s assurance that funds will be available once they meet the required conditions. Before issuing the LC, the bank typically assesses the buyer’s financial position to ensure that the amount being guaranteed is properly supported by collateral or creditworthiness.
Because an LC is considered a negotiable instrument, its payment can be made directly to the beneficiary or routed through another bank designated by the issuing institution. In some arrangements, the beneficiary can even transfer the right to draw funds to another party, often seen in cases where intermediaries operate between producers and final buyers.
Globally, the rules guiding these transactions are standardized through the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits. These rules help maintain consistency, reduce disputes, and ensure that banks across countries follow similar procedures.
Typical Costs Involved in Using Letters of Credit
Banks do not provide guarantees for free. When a letter of credit is issued, the bank charges a fee, usually calculated as a percentage of the amount being guaranteed. The exact percentage varies from one institution to another, and may increase depending on the transaction’s perceived risk. A simple commercial LC may carry a modest fee, while a confirmed LC involving multiple banks or more volatile markets may cost significantly more.
Moreover, different types of LCs come with different pricing structures. For example, unconfirmed credits tend to be less expensive because only one bank bears the obligation. Confirmed credits, which require the participation of a second bank guaranteeing payment, often cost more due to the additional risk absorbed by both institutions.
These costs, though sometimes substantial, are generally accepted as necessary in situations where the seller would otherwise refuse to ship goods without upfront payment.
Major Types of Letters of Credit
Depending on the nature of the transaction, businesses can choose from several specialized forms of letters of credit. Each serves a unique purpose and fits different commercial scenarios.
Commercial letter of credit
Standby letter of credit
Revolving letter of credit
Traveler’s letter of credit
Confirmed letter of credit
Red clause or unsecured letter of credit
Each type is designed to handle specific risks, payment structures, or trade relationships.
Commercial Letters of Credit
A commercial letter of credit is the most direct and widely used form. In this arrangement, the issuing bank pays the seller once the required documents—often shipping records, invoices, or certificates—are presented. It functions as a primary payment mechanism rather than a backup option. This structure is especially useful when dealing with new trading partners or in regions where verifying a buyer’s financial strength may be difficult.
Standby Letters of Credit
A standby letter of credit functions differently from a commercial LC. Instead of guaranteeing payment for goods immediately after shipment, a standby LC activates only if the buyer or contracted party fails to deliver on their obligation. In other words, it works more like a safety net—similar to an insurance policy—ensuring that the beneficiary receives compensation if performance failures occur. These are often used in service agreements, construction contracts, or long-term projects where performance guarantees are essential.
Revolving Letters of Credit
Some trade relationships involve repetitive shipments or ongoing purchases. A revolving letter of credit supports these arrangements by allowing multiple draws over a specified period, up to an agreed limit. Instead of creating a new LC for every shipment, the revolving feature resets either after each draw or after a certain time frame. This provides convenience and efficiency for businesses that maintain frequent and predictable trade cycles.
Traveler’s Letters of Credit
Before digital banking made global withdrawals easy, travelers often relied on letters of credit to access funds abroad. While less common today, these instruments historically allowed individuals to present drafts to designated banks while traveling internationally. Even now, certain industries and specialized travel circumstances still use them to ensure that funds are accessible in regions with limited digital financial infrastructure.
Confirmed Letters of Credit
A confirmed letter of credit adds an additional layer of security. In this setup, a second bank—usually the seller’s bank—guarantees the payment alongside the issuing bank. This becomes especially valuable when the seller has concerns about the buyer’s country, banking system, or political climate. The confirming bank essentially stands in as a trusted guarantor, ensuring that payment will be honored even if the issuing bank fails to do so.
Example of Letters of Credit in Global Markets
Large international banks frequently provide letters of credit in regions where obtaining direct credit is difficult. For instance, global institutions often assist buyers in emerging markets across Africa, Latin America, the Middle East, and parts of Asia by issuing LCs that exporters around the world trust. When a reputable international bank confirms an LC, sellers feel more comfortable supplying goods into markets where banking or political instability may otherwise deter them. This enables trade flows that might not occur without additional financial guarantees.
Steps to Applying for a Letter of Credit
Because letters of credit involve strict documentation, preparing them carefully is essential. Errors or missing documents can delay payments or even invalidate the LC entirely.
A typical import-export setup unfolds as follows:
The buyer and seller negotiate and finalize the sales agreement, specifying shipment terms, payment expectations, and documentation requirements.
The buyer approaches their bank with this agreement, requesting issuance of a letter of credit.
The issuing bank prepares the LC and forwards it to the seller’s bank for review.
Once the seller’s bank approves the wording, it shares the LC with the seller.
The seller ships the goods and gathers all required documents exactly as stated in the LC.
The seller submits these documents to their bank, which verifies compliance.
If everything matches, the documents move to the buyer’s bank, and payment is released to the seller.
This sequence demonstrates how letters of credit structure the entire transaction, reducing misunderstandings and ensuring accountability.
Advantages and Drawbacks of Letters of Credit
Letters of credit bring significant benefits but also come with limitations.
On the positive side, they create certainty for both buyer and seller. Sellers receive payment assurance, while buyers only release funds once the goods are shipped as agreed. LCs also introduce clarity to complex transactions by defining exactly what needs to occur at each step. They can even personalize terms, allowing businesses to tailor requirements to their deal.
However, buyers typically carry the financial burden of LC fees. In addition, not every scenario can be perfectly anticipated in an LC, leaving space for human error or disputes over documentation. Processing an LC can also be time-intensive, especially when multiple banks are involved. Economic or political changes in a country may further complicate the process.
Final Thoughts
Letters of credit remain one of the most important tools in global commerce. Whether used for large industrial shipments or smaller international purchases, they create a framework that protects both sides of a transaction. For businesses exploring international markets, the first step is often to speak with their bank about available options. Larger banks typically offer broader global networks and more specialized LC services, while smaller institutions may provide more personalized guidance. No matter the route, understanding how letters of credit work can unlock safer, more efficient participation in international trade.
Frequently Asked Questions (FAQs)
What is the primary purpose of a letter of credit?
A letter of credit exists to provide payment assurance in transactions where the buyer and seller may not fully trust each other. It shifts the financial risk from the seller to the issuing bank, ensuring the seller receives payment once the agreed conditions are met.
Why do banks require collateral before issuing a letter of credit?
Banks assume significant risk when guaranteeing payments, so they require collateral or proof of creditworthiness. This ensures the bank can recover the amount if the buyer fails to reimburse them after the payment is made to the seller.
Are letters of credit used only in international trade?
While they are most common in global trade, letters of credit can also be used in domestic transactions involving large contracts, construction projects, or performance guarantees where additional security is needed.
What documents are normally required to trigger payment under an LC?
Common documents include commercial invoices, bills of lading, insurance certificates, packing lists, and inspection certificates. These documents must match the LC terms exactly for the bank to release payment.
How long does it take for a bank to issue a letter of credit?
The timeline varies depending on the bank, the complexity of the transaction, and the buyer’s credit approval process. It may take anywhere from a few days to several weeks to finalize.
Can a letter of credit be amended once issued?
Yes, an LC can be amended if both the buyer and seller agree. Amendments may involve extending shipment dates, adjusting amounts, or updating documentation requirements.
What is the difference between a confirmed and unconfirmed LC?
An unconfirmed LC relies solely on the issuing bank’s guarantee, while a confirmed LC adds a second bank’s guarantee—usually the seller’s local bank—providing extra security in higher-risk markets.
Can letters of credit expire?
Yes. Every LC has a stated expiry date, after which documents will not be honored. Sellers must meet deadlines for shipment and document presentation to ensure payment.
Do revolving letters of credit automatically renew?
Some revolve by time (renewing automatically every month or quarter), while others revolve by value (resetting the credit limit after each draw). The renewal conditions depend entirely on the agreement.
Who usually pays the fees for a letter of credit?
Typically, the buyer pays the fees because the LC is issued on their behalf. However, fee arrangements can be negotiated between parties and noted in the sales contract.
Are standby letters of credit used for payment?
Not typically. Standby letters of credit function more like performance guarantees. They pay only when the buyer or contracted party fails to perform or default occurs.
Can a beneficiary transfer their rights under a letter of credit?
Only transferable letters of credit allow this. The beneficiary can assign their right to draw funds to another party, such as a supplier or partner involved in fulfilling the transaction.