A letter of credit (LC), usually a documentary credit, is an irrevocable undertaking by an issuing bank to honour a payment when the beneficiary presents documents that comply with the credit’s terms. Banks examine those documents rather than the physical goods, so the LC remains separate from the underlying sales contract.
The documents control the bank’s decision
An exporter can ship conforming goods and still face a delayed or refused payment if the presentation doesn’t match the credit. A misspelled party name, late transport document or inconsistent amount may be enough to create a discrepancy. The issuing bank is testing documentary compliance, not inspecting the shipment.
The US International Trade Administration describes an LC as a bank commitment to pay an exporter after the required shipping documents are presented and approved. It also warns that errors and discrepancies can delay payment and add fees.
Source: International Trade Administration, Letter of Credit
Who does what?
| Party | Role | Main concern |
|---|---|---|
| Applicant | Importer or buyer that asks for the credit | Credit terms, bank charges and access to shipping documents |
| Issuing bank | Issues the credit at the applicant’s request | Whether the presentation complies with the credit |
| Advising bank | Checks apparent authenticity and advises the credit | Passing the credit to the beneficiary accurately |
| Confirming bank | May add its own undertaking when authorised or requested | Issuing-bank and country risk |
| Beneficiary | Exporter or seller entitled to present documents | A complying presentation before expiry |
From application to payment
- The buyer and seller agree on the commercial terms and the documents the credit should require.
- The buyer applies to its bank. If approved, that bank issues the LC in favour of the seller.
- An advising bank checks the apparent authenticity of the credit and sends it to the seller.
- After shipment, the seller presents the specified documents through the nominated or advising bank.
- The relevant banks examine the presentation. Payment follows under the LC when the documents comply.
An amendment changes the credit only after the relevant parties accept it. Shipping first and trying to repair an unworkable document requirement later can leave the exporter with goods in transit and no complying presentation.
Where UCP 600 fits
The International Chamber of Commerce’s UCP 600 rules apply when the text of the credit expressly makes them applicable. The rules define the parties, a complying presentation and the issuing bank’s undertaking. They also separate credits from contracts and state that banks deal with documents rather than goods, services or performance.
How an LC changes the payment risk
| Arrangement | Payment trigger | Who carries more risk? |
|---|---|---|
| Letter of credit | A complying presentation under the credit | Document risk sits with the seller; the buyer pays bank fees and uses its banking line |
| Open account | The buyer pays under the invoice terms | The seller carries more risk until payment arrives |
| Advance bank transfer | The buyer pays before shipment | The buyer carries more performance and delivery risk |
Before asking a bank to issue the LC
Keep the document list as short as the transaction allows. Every extra condition creates another opportunity for mismatch, review time and amendment cost.
- Confirm which bank will issue and advise the credit
- Decide whether confirmation is necessary
- Set the expiry date, presentation period and place for presentation
- Require only documents the seller can produce exactly
- Assign issuance, amendment, confirmation and discrepancy charges
- Agree on the payment currency and final bank route
Letter of credit and Quotable Payments
A letter of credit is a documentary bank undertaking. Quotable Payments covers eligible approved transfer routes, so the two shouldn’t be treated as interchangeable. For an invoice paid outside an LC, compare the rate, fees, expected Recipient amount and settlement conditions before authorisation.
Continue with international vendor payments, wire transfer and payment authorization.
