Letter of Credit

A letter of credit (LC) is a written guarantee issued by a bank on behalf of a buyer, promising to pay the seller a specified amount once the seller presents the required shipping documents by the deadline. The payment obligation shifts from the buyer to the bank. Because banks are considered lower credit risks than most corporations, the seller gets meaningfully stronger payment assurance than a simple purchase order or invoice provides.

Letters of credit are the dominant payment tool in international trade between parties who do not know each other and cannot easily assess each other's creditworthiness.

Four Parties Make the Mechanism Work

A standard letter of credit transaction involves four roles, each with a defined responsibility.

• Applicant (importer): The buyer who requests the bank to issue the LC. They provide collateral or use their credit line to secure the bank's guarantee.
• Issuing bank: The importer's bank. It drafts the LC based on the agreed sales contract terms and commits to pay once compliant documents are presented.
• Advising bank: The exporter's local bank. It authenticates the LC and forwards it to the exporter, but does not guarantee payment unless it also confirms the credit.
• Beneficiary (exporter): The seller who ships the goods and presents documents to the advising bank to trigger payment.

Payment Triggers on Documents, Not on Goods

The bank pays when you present the right paperwork, not when the goods are verified at the destination. Standard required documents typically include a commercial invoice, a bill of lading proving shipment, a packing list, a certificate of origin, and an insurance certificate.

Every detail must match exactly. A misspelled company name, a wrong date, or a quantity that differs from the invoice by even one unit is a discrepancy that can delay or block payment. Trade Finance Global notes that the Uniform Customs and Practice for Documentary Credits (UCP 600), issued by the International Chamber of Commerce, governs how banks interpret these requirements globally.

The LC Protects Both Sides of the Transaction

The US International Trade Administration explains the mutual protection clearly. As an exporter, you are protected against non-payment as long as your documents comply with the LC terms. As an importer, you are protected because payment is only released when the exporter proves the goods were shipped in accordance with your specifications. Neither party has to trust the other's word because the bank stands between them.

Revocable vs. Irrevocable, and Confirmed vs. Unconfirmed

An irrevocable LC cannot be changed or cancelled without the consent of all parties. This is the standard type in international trade because it protects the exporter from the buyer backing out after shipment. A revocable LC can be modified by the issuing bank at any time without the seller's consent, which makes it nearly useless as a trade finance tool.

A confirmed LC adds the advising bank's own payment guarantee on top of the issuing bank's. This matters when the issuing bank is in a high-risk country and the exporter wants the additional backing of a bank in their own jurisdiction.

Sources

• US International Trade Administration – https://www.trade.gov/letter-credit
• Wikipedia – Letter of Credit – https://en.wikipedia.org/wiki/Letter_of_credit
• Corporate Finance Institute – https://corporatefinanceinstitute.com/resources/commercial-lending/letter-of-credit/
• BDC Canada – https://www.bdc.ca/en/articles-tools/marketing-sales-export/export/what-is-a-letter-of-credit
• Trade Finance Global – https://www.tradefinanceglobal.com/letters-of-credit/