Understanding Letters of Credit
A Letter of Credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller (beneficiary) on behalf of a buyer (applicant), provided the seller presents documents that comply with the terms specified in the LC. It serves as a secure payment mechanism that protects both parties in domestic and international trade transactions.
In international trade, where buyers and sellers may not know each other and operate across different legal jurisdictions, LCs provide the trust bridge necessary for transactions. The seller gets assurance of payment from a bank rather than relying solely on the buyer's creditworthiness, while the buyer is assured that payment will only be made upon presentation of compliant documents proving shipment of goods.
Key Principles of Letters of Credit
- Independence Principle: The LC is independent of the underlying sales contract
- Documents Only: Banks deal with documents, not goods or services
- Strict Compliance: Documents must strictly comply with LC terms
- Bank's Undertaking: Issuing bank's payment obligation is primary
Parties Involved in LC
Applicant (Importer/Buyer)
The party who requests the bank to issue the LC. They are obligated to reimburse the issuing bank once payment is made to the beneficiary.
Issuing Bank
The bank that issues the LC at the applicant's request and undertakes to pay the beneficiary upon presentation of compliant documents.
Beneficiary (Exporter/Seller)
The party in whose favor the LC is issued. They receive payment upon presenting documents that comply with the LC terms.
Advising Bank
The bank that advises the LC to the beneficiary, typically located in the beneficiary's country. It verifies the authenticity of the LC.
Additional Parties
- Confirming Bank: Adds its own undertaking to pay, providing additional security to the beneficiary
- Negotiating Bank: Purchases the beneficiary's documents and claims reimbursement
- Reimbursing Bank: The bank authorized to honor reimbursement claims from negotiating/paying banks
Types of Letters of Credit
By Payment Method
Sight LC
Payment is made immediately upon presentation of compliant documents. The beneficiary receives funds without delay once documents are verified.
Usance LC (Time/Term LC)
Payment is deferred to a future date, typically 30, 60, 90, or 180 days after presentation or bill of lading date. Allows the buyer time to sell goods before payment.
Deferred Payment LC
Similar to usance LC but without a draft. Payment is made on a specified future date without the formality of accepting a bill of exchange.
By Security Level
Confirmed LC
A second bank (usually in the beneficiary's country) adds its guarantee to the LC. Used when the issuing bank's creditworthiness is uncertain or for high-risk countries.
Unconfirmed LC
Only the issuing bank's undertaking is available. The advising bank merely notifies the beneficiary without adding its own guarantee.
Special Types
- Transferable LC: Allows the beneficiary to transfer part or all of the amount to one or more second beneficiaries
- Back-to-Back LC: Used by intermediaries where a new LC is issued based on the backing of a master LC
- Revolving LC: Automatically reinstates after utilization, either by time or value
- Standby LC: A guarantee of payment if the applicant defaults, rather than a primary payment mechanism
LC Process Flow
Sales Contract
Buyer and seller agree on terms including LC as payment method, specifying amount, validity, documents required, and shipment terms.
LC Application
Applicant approaches their bank to issue LC, providing application form, sales contract, and margin/security.
LC Issuance
Issuing bank drafts LC as per instructions and sends it to the advising bank in beneficiary's country via SWIFT.
LC Advice
Advising bank verifies authenticity and notifies beneficiary. If confirmed, adding bank also provides its undertaking.
Shipment
Beneficiary ships goods as per LC terms and collects transport documents from shipping company.
Document Presentation
Beneficiary prepares all required documents and presents to negotiating/advising bank within LC validity.
Document Checking
Bank examines documents for compliance with LC terms within 5 banking days (UCP 600).
Payment
If documents comply, bank pays/accepts draft. For usance LCs, draft is accepted for payment at maturity.
UCP 600 Rules
The Uniform Customs and Practice for Documentary Credits (UCP 600) is the international standard governing LCs, published by the International Chamber of Commerce (ICC). Most LCs worldwide are subject to UCP 600.
Key Articles
Article 2 - Definitions
Defines key terms including honour, negotiation, presentation, and confirming bank.
Article 7 - Issuing Bank Undertaking
The issuing bank undertakes to reimburse the nominated bank that honours or negotiates.
Article 14 - Standard for Examination
Banks have 5 banking days to examine documents and must determine if they appear on their face to constitute complying presentation.
Article 16 - Discrepancies
If documents are discrepant, bank must give notice within 5 banking days, stating each discrepancy and status of documents.
Documents Required
An LC specifies documents the beneficiary must present to receive payment. Documents must strictly comply with LC terms.
Common Documents
- Commercial Invoice: Shows goods description, quantity, price. Must match LC description exactly.
- Bill of Lading (B/L): Transport document evidencing shipment. Must be clean and show correct ports.
- Packing List: Details contents of each package, weights, and measurements.
- Certificate of Origin: Certifies goods' country of manufacture, needed for customs duty.
- Insurance Policy: Required for CIF/CIP terms, showing coverage as per LC requirements.
- Inspection Certificate: Certifies quality/quantity as per contract, often by independent agency.
Document Compliance Tips
- • Use exactly the same goods description as in the LC
- • Ensure all dates align (invoice date before B/L date)
- • Verify all required documents are included
- • Check that documents are signed where required
- • Ensure consistency of data across all documents
Handling Discrepancies
Discrepancies are document defects that don't comply with LC terms. They can delay payment or lead to refusal.
Common Discrepancies
- • Late presentation after expiry date
- • Description of goods not matching LC
- • Late shipment after latest date allowed
- • Missing required documents
- • B/L not showing "clean on board"
- • Amount drawn exceeding LC amount
- • Inconsistencies between documents
Options When Discrepancies Exist
Request Amendment
If caught before presentation, ask beneficiary to correct documents.
Telecommunication
Send documents on collection basis with instructions to contact applicant for waiver.
Applicant Waiver
Bank contacts applicant to accept discrepant documents. Applicant may accept with reduced payment.
Conclusion
Letters of Credit remain one of the most secure payment methods in international trade, providing assurance to both buyers and sellers. While they involve costs and documentary complexity, the protection they offer against payment and delivery risks makes them indispensable for global commerce.
Success with LCs requires attention to detail in document preparation, understanding of UCP 600 rules, and clear communication between all parties. Exporters should invest in training their documentation teams to minimize discrepancies and ensure smooth payment.
Whether you are an importer seeking supply security or an exporter needing payment assurance, mastering the Letter of Credit process is essential for successful international trade operations.