Letter of Credit

Definition

Letter of Credit is a documentary trade finance instrument issued by a bank on behalf of a buyer, committing the bank to pay a seller up to a stated amount if the seller presents the exact documents required by the credit within the permitted time and in full compliance with its terms.

What is a Letter of Credit?

A letter of credit is used in domestic and international trade when buyer and seller need a structured payment mechanism that reduces counterparty risk. The seller wants assurance that payment will be made if shipment occurs correctly. The buyer wants the bank to release funds only when documentary evidence shows that the agreed shipment and contractual conditions have been met. The bank sits between the parties and substitutes its credit standing for part of the buyer’s payment risk.

Unlike open account trading, payment under a letter of credit depends on documents, not on the bank verifying the physical condition of the goods. That makes document precision central to the instrument.

How a Letter of Credit Works

The buyer applies for the credit through its bank, often called the issuing bank. The issuing bank sends the credit to an advising bank in the seller’s country. The seller ships the goods and presents the required documents, such as commercial invoice, transport document, packing list, insurance certificate, or certificate of origin, depending on the credit terms. If the documents comply, the bank honors or negotiates the credit and payment is made according to the agreed sight or usance terms.

If the documents contain discrepancies, the bank may refuse payment or request the buyer’s approval to accept the discrepancy. Because banks deal in documents rather than goods, even small inconsistencies in dates, wording, quantities, or document format can create payment delay.

Types of Letter of Credit

Common forms include revocable and irrevocable credits, although modern trade practice overwhelmingly uses irrevocable credits. Credits may also be confirmed, where a second bank adds its own payment undertaking, or transferable, where the beneficiary can transfer rights to another party under certain conditions. Sight credits pay when compliant documents are presented, while usance credits pay at a future maturity date.

The specific type chosen depends on country risk, buyer credit strength, transaction complexity, and the level of assurance the seller requires.

Key Documents and Compliance

The effectiveness of a letter of credit depends on the exact wording of the documentary requirements. The credit should specify what documents are required, who must issue them, when they must be dated, and how they must align with shipment terms. Poorly drafted credits create operational friction because sellers may find compliance difficult even when the shipment itself is correct.

Trade teams therefore review credits carefully before shipment. Banks examine documents against the credit and standard rules such as UCP, but they do not act as product inspectors or contract managers. Documentary compliance is the payment trigger.

Letter of Credit in Procurement and Trade Risk

Procurement may encounter letters of credit when sourcing internationally from suppliers that require bank backed payment assurance, especially in new trading relationships, politically exposed jurisdictions, or high value capital purchases. The instrument can reduce non payment risk for the supplier, but it also adds banking fees, administrative effort, and strict documentation obligations for both sides.

It is therefore most useful where trust, country risk, or transaction value justifies the added control and formality.

Frequently Asked Questions about Letter of Credit

What risk does a letter of credit reduce?

A letter of credit mainly reduces payment risk for the seller because a bank undertakes to pay if compliant documents are presented. It also gives the buyer a level of control because the seller must satisfy documentary conditions before funds are released. However, it does not remove all trade risk. Goods can still be defective, late, or commercially unsuitable even if the documents are compliant.

Does a letter of credit guarantee that the goods are correct?

No. Banks deal with documents, not with the physical goods behind them. If the invoice, bill of lading, and other required papers comply with the letter of credit, the bank may still pay even if the buyer later disputes product quality or specification. Buyers that need physical verification usually rely on inspections, contractual protections, and quality controls alongside the credit.

What happens if the documents do not match the letter of credit exactly?

If documents are discrepant, the bank can reject them or seek a waiver from the buyer before payment is made. Common discrepancies include inconsistent product descriptions, incorrect shipment dates, missing signatures, or quantity mismatches. Even minor documentary errors can delay payment, which is why sellers and trade operations teams review the credit carefully before shipment and again before presentation.

When would a supplier ask for a confirmed letter of credit?

A supplier may request confirmation when it wants assurance not only from the buyer’s issuing bank but also from a second bank, often located in the seller’s market. This is common when the seller is concerned about country risk, the issuing bank’s credit quality, or transfer restrictions. Confirmation gives the beneficiary an additional payment commitment, but it also increases transaction cost.