A letter of credit (LC), also known as a documentary credit, is a financial instrument issued by a bank that provides a written payment commitment to a seller (the beneficiary) on behalf of a buyer (the applicant). The issuing bank agrees to pay the seller a specified amount, provided the seller presents documents that strictly comply with the terms and conditions outlined in the LC. Letters of credit are a cornerstone of international trade finance, providing payment security to both buyers and sellers when transacting across borders where trust, legal frameworks, and commercial relationships may not yet be established.
LCs reduce the risk inherent in international trade: the seller is assured of payment (assuming document compliance), and the buyer is assured that payment will only be made once the required shipping and commercial documents are presented. This mechanism has facilitated global commerce for centuries and remains essential for high-value cross-border transactions.
How Does a Letter of Credit Work?
The LC process involves multiple parties, including the buyer, seller, issuing bank, and advising bank, and follows a structured document flow:
Step 1: Agreement. The buyer and seller negotiate the terms of a commercial transaction and agree to use a letter of credit as the payment mechanism. The LC terms, including the amount, required documents, shipping deadlines, and expiry date, are defined in the sales contract.
Step 2: Application. The buyer applies for an LC from their bank (the issuing bank), providing complete details of the transaction including the beneficiary’s name, the amount, the required documents, the latest shipping date, and the LC expiry date.
Step 3: Issuance. The issuing bank reviews the application, assesses the buyer’s creditworthiness, and issues the LC. The LC is transmitted to the seller’s bank (the advising bank), typically via the SWIFT network.
Step 4: Advising. The advising bank authenticates the LC to confirm it is genuine and notifies the seller of its terms and conditions. At this stage, the seller can review the LC to ensure compliance is achievable before shipping.
Step 5: Shipment. The seller manufactures or procures the goods, arranges shipment according to the LC terms, and prepares the required documents: commercial invoice, bill of lading or transport document, packing list, certificate of origin, insurance certificate, and any inspection certificates specified in the LC.
Step 6: Document presentation. The seller presents the complete set of documents to the advising bank within the presentation period specified in the LC. The advising bank performs an initial review and forwards the documents to the issuing bank.
Step 7: Examination. The issuing bank examines the documents for strict compliance with the LC terms. Under UCP600 (the governing framework for LCs), banks have a maximum of 5 banking days to examine documents and decide whether to honor or refuse.
Step 8: Payment or refusal. If the documents are compliant, the issuing bank makes payment to the seller (either directly or through the advising bank). If discrepancies are found, the bank issues a notice of refusal and provides the presenter an opportunity to correct the documents or seek a waiver from the buyer.
The Four Main Types of Letters of Credit
Revocable Letter of Credit
A revocable LC can be amended or canceled by the issuing bank at any time without prior notice to the beneficiary. Because it provides virtually no payment security to the seller, revocable LCs are extremely rare in modern international trade and are generally not recommended for commercial transactions.
Irrevocable Letter of Credit
An irrevocable LC cannot be amended, modified, or canceled without the written consent of all parties involved, including the beneficiary. This is the standard form used in international trade because it provides strong, binding payment assurance to the seller. Under UCP600, all LCs are irrevocable unless they explicitly state otherwise.
Confirmed Letter of Credit
A confirmed LC carries the payment commitment of both the issuing bank and a second bank (the confirming bank, often the advising bank). This adds a second layer of bank obligation, which is particularly valuable when the issuing bank is located in a country with political instability, currency controls, or elevated financial risk. The confirming bank’s guarantee protects the seller even if the issuing bank cannot fulfill its obligation.
Unconfirmed Letter of Credit
An unconfirmed LC carries only the issuing bank’s commitment. The advising bank transmits the LC to the beneficiary without adding its own guarantee. This is less costly than a confirmed LC but provides less protection to the seller, particularly when dealing with banks in higher-risk jurisdictions.
Other Types of Letters of Credit
Standby LC: Functions as a backup payment mechanism. The standby LC is drawn upon only if the buyer fails to fulfill their payment obligation through normal channels. It serves as a safety net rather than a primary payment method.
Transferable LC: Allows the original beneficiary to transfer all or part of the LC rights to one or more secondary beneficiaries. This is commonly used by intermediaries and trading companies who source goods from multiple suppliers.
Back-to-Back LC: Used in intermediary transactions where the middleman uses the original LC as collateral to open a second LC in favor of the actual supplier. This allows the intermediary to facilitate the transaction without using their own capital.
Revolving LC: Automatically renews for a specified amount and period, covering multiple shipments without the need to issue a new LC for each transaction. This is efficient for ongoing trading relationships with regular shipment schedules.
Documents Required for a Letter of Credit
The exact documentary requirements are specified in each LC and must be followed precisely. Common required documents include: commercial invoice (matching the LC description of goods exactly), bill of lading or transport document (proving shipment was made as specified), packing list (detailing the contents of each package), certificate of origin (verifying where the goods were manufactured), insurance certificate (covering the goods during transit), and inspection certificates (from independent surveyors, if required by the LC). Strict document compliance is the single most critical factor in LC transactions, even minor discrepancies can result in payment delays or refusal.
Advantages and Disadvantages
| Advantages | Disadvantages |
| Strong payment security for the seller when documents comply | High bank fees, typically ranging from 0.25% to 2% of contract value |
| Reduces counterparty risk in cross-border transactions | Complex documentation requirements with strict compliance standards |
| Governed by UCP600, providing international legal consistency | Document discrepancies can delay payment significantly |
| Can be confirmed for additional security against bank risk | Time-consuming and administratively intensive to set up |
| Enables trade between parties without established trust | Ties up the buyer’s credit line with the issuing bank |
| Provides legal certainty independent of local court systems | Amendments require agreement from all parties and incur fees |
Letter of Credit vs. Bank Guarantee
While both instruments involve a bank’s financial commitment, they serve fundamentally different purposes. A letter of credit is a primary payment mechanism, the bank pays when the beneficiary presents compliant documents, regardless of whether a default has occurred. A bank guarantee is a secondary instrument, the bank pays only if the applicant defaults on their contractual obligation. In essence, an LC is proactive (payment is the expected outcome), while a bank guarantee is reactive (payment occurs only upon failure). The choice between the two depends on the nature of the transaction and the risk each party is trying to mitigate.
Letters of Credit and UCP600 Compliance
The Uniform Customs and Practice for Documentary Credits (UCP600) is the governing framework for letters of credit worldwide. Published by the International Chamber of Commerce (ICC) and implemented in 2007, UCP600 establishes comprehensive rules for the issuance, amendment, presentation, examination, and honor or dishonor of documentary credits. It applies to all LCs that expressly indicate they are subject to UCP600, and in practice, virtually all commercial LCs include this reference.
Key UCP600 provisions include: banks deal with documents only, not with goods or services (Article 5); a maximum of 5 banking days for document examination (Article 14); standards for what constitutes a compliant document presentation; and rules governing the roles and obligations of issuing banks, confirming banks, and advising banks. Compliance with UCP600 provides legal predictability and reduces disputes between the parties.
Letter of Credit vs. Supply Chain Finance
Letters of credit are designed to manage payment risk in international trade transactions between parties that may not have established relationships or trust. They require extensive documentation, bank intermediation, and carry significant administrative costs. Supply chain finance (SCF), by contrast, is designed for established domestic (or international) buyer-supplier relationships where the primary goal is to optimize working capital and payment terms, not to mitigate counterparty payment risk.
Zenith Group Advisors’ SCF program is tailored for middle-market companies in sectors likemanufacturing andretail and consumer goods. It provides insurance-backed, unsecuredaccounts payable financing without the overhead of documentary credit processes, bank credit lines, or complex document compliance. Where an LC might take weeks to arrange and cost 1–2% of the transaction value in bank fees, Zenith’s SCF program can be implemented in as little as 7 to 10 days. Learn more abouthow it works.
Frequently Asked Questions
How much does a letter of credit cost?
U.S. bank LC fees typically range from 0.25% to 2% of the contract value, depending on the type of LC, the risk profile of the transaction, the issuing bank’s terms, and whether confirmation is required. Additional fees may apply for amendments, document examination, and SWIFT transmission.
What happens if documents are not compliant under an LC?
The issuing bank will issue a discrepancy notice identifying the specific non-compliant elements. The seller can amend and re-present the documents within the LC’s validity period, request a waiver from the buyer, or accept that the LC may not be honored if discrepancies cannot be resolved.
Is a letter of credit the same as trade credit?
No. A letter of credit is a bank-intermediated payment instrument with formal documentary requirements. Trade credit is a bilateral arrangement between buyer and seller where the seller extends payment terms without bank involvement or documentary compliance requirements.
When should I use an LC instead of supply chain finance?
LCs are appropriate when trading with unfamiliar parties, entering new international markets, dealing with high-value one-off transactions, or when the seller requires bank-backed payment assurance. SCF is better suited for established relationships where the focus is working capital optimization rather than payment risk mitigation.
Are LCs required for international trade?
No. Many international transactions are conducted on open account terms (trade credit), cash in advance, or documentary collections. LCs are used when the transaction risk warrants the cost and complexity of bank intermediation.
IMPORTANT NOTE: This article is for informational purposes only and does not constitute legal, financial, or trade compliance advice. Letter of credit terms, costs, and UCP600 interpretations vary by institution, jurisdiction, and transaction structure. Consult a qualified trade finance advisor before structuring any international trade instruments.
Looking for a simpler alternative to documentary credits for your domestic supply chain? Explore Zenith Group Advisors’ supply chain finance programHow It Works orContact Us.
