What is a Letter of Credit? A Comprehensive Guide to Its Importance in Trade

Last Updated on April 1, 2025 by Caesar

The global village, with which the modern world is labelled, thrives on cross-border trade. A deal that involves both buyers and sellers across borders can never be absolutely void of any chance of risks. Lack of faith, a difference of law and custom, or just about anything could widen a crack between the two parties involved. Here’s when a letter of credit could do an extremely important job of saving a possible broken deal. The letter of credit basically works like a guarantee to settle payment on behalf of the buyer towards the seller for an agreed-upon amount. This protects the buyer as well in making confirmation of the contract terms.

The following guide defines what a Letter of Credit is, how it works, its types, benefits, and why it is indispensable in international trade.

What is a Letter of Credit?

Letters of Credit involve payment instruments issued through banks or a related financial organization at the instance of the applicant buyer, committing in writing the certainty that the beneficiary vendor is paid provided terms and conditions involved therein in documentation are attained to satisfaction.

It is especially important in international trade, where buyers and sellers usually do not know each other and also belong to different jurisdictions. The LC minimizes risks for both parties because it involves a bank as an underwriter who assumes the financial responsibility.

How a Letter of Credit Works:

One process of LC involves essentially four parties:

1. Applicant: 

This is the buyer, who would approach his bank for an LC to be issued to a seller in assurance of the payment.

2.  Issuing Bank: 

It is the bank that issues an LC and undertakes commitment to the seller upon presentation of some stipulated conditions regarding the obligation of payment.

3.  Beneficiary (Seller): 

This is the party who receives the money after the respective terms of the LC are met.

4.  Advising Bank: 

It is an intermediary bank that confirms the LC and advises on the forwarding of the documents.

Steps in LC Process:

1. The buyer approaches his bank and opens an LC.
2. The issuing bank sends the LC to the seller’s advising bank.
3. Following which, the seller checks an LC and ships goods under an agreement.
4. The seller sends the required documents, which may include a bill of lading and invoice, to the advising bank.
5. Advising bank checks the documents and informs the issuing bank accordingly.
6. The issuing bank, upon verification, issues the payment to the seller.

Documents Needed for a Letter of Credit

A number of the documents which are very important in the smooth issuance of an LC are as under:

• Application Form: Contains information about the buyer and the transaction involved.
• KYC Documents: Applicant and beneficiary verification.
• Commercial Documents: Invoice, bill of exchange, and packing list.
• Shipping Documents: Bill of lading or airway bill.
• Certificates: Origin and inspection certificates.
• Insurance Documents: The policy or certificate covering goods.

Letters of Credit Types

There are many types of LCs, each serving a different purpose in trade. Some of the most common varieties include the following:

1. Commercial LC

This is issued where the issuing bank pays the seller upon the satisfying of all conditions.

2. Standby LC

It is a backup payment method for the seller in case of default by the buyer.

3. Confirmed LC

The second bank, in the seller’s home country, jointly guarantees payment with the issuing bank and thus provides an extra layer of security.

4. Revolving LC

LC suitable for the recurring letter of credit transaction; this LC allows various payments during the specified time.

5. LC-Red Clause

Allows the seller to get funds upfront of shipping and, therefore, gives working capital.

6. LC Transferable

Enables the initial beneficiary to transfer credit to secondary beneficiaries, often used by intermediaries.

7. Back-to-Back LC

This allows for the trade between intermediaries by issuing two LCs, one to the supplier and the other to the buyer.

Advantages of a Letter of Credit

Being one of the most prevalent modes of payment in case of international purchase and sale activities, a letter of credit implies several advantages.

For Sellers:

• Payment Assurance: It ensures or guarantees payment once there is compliance with the LC terms.
• Reduced Risks: Lowers the level of exposure to the buyer’s risk, which may come in the form of insolvency or default.
• Global Acceptance: It is globally recognized and accepted as quite a secure method of paying against goods and services.

For Buyers:

• Assurance of Goods: This assurance guarantees goods will be shipped as agreed upon terms before the actual payment.
• Flexible payment: Payment plans can be deferred, which is friendly to cash flow management.
• Reduced Counterparty Risk: Payment is made against documents, not against the seller’s performance.

Disadvantages of Letter of Credit

While having many advantages, an LC also has a number of disadvantages:

• High Cost: There is an issuing bank charge that is usually borne by the buyer.
• Complexity: There is a lot of documentation involved in the process, and the terms are pretty strict.
• Time-Consuming: Verification of documents may delay making the payment.

Common Misconceptions about Letters of Credit

1. Only Large Companies Use LCs

This is contrary to the belief that SMEs can also use LCs in the extension of international trade through different platforms.

2. Guaranteed Payment Regardless of Errors

Although the LCs offer some sort of financial security, the payment depends upon the submission of documents in the correct form and on time.

3. Equal to Bank Guarantee

While similar in nature, LCs cover payment upon satisfaction of conditions while a bank guarantee compensates against non-performance.

Real Life Sample of LC

Suppose an exporter in India is exporting goods to a buyer in Europe. The buyer issues an LC through his bank, ensuring the payment once the exporter presents the shipping documents, which mainly include a bill of lading and invoice. Therefore, this protects both parties and builds confidence into possibly even first-time transactions.

Endnote

The Letter of Credit in the complex world of international trade is like a bridge of mutual trust between the buyer and seller. Since it ensures payment upon presentation of compliance, it reduces financial risks for both parties involved and facilitates easier transactions. With an LC in place, you can focus on growth while leaving the financial risks behind. Learn more about Letters of Credit and how they can revolutionize the way you trade. Start your journey of export initiated, confident in your security of payment!