Letter of credit explained: parties, process and types

What is a letter of credit?

A letter of credit (L/C) is a conditional payment undertaking given by the buyer’s bank to the seller. The bank undertakes to pay if the documents listed in the credit, such as the invoice, bill of lading, insurance document and certificate of origin, are presented on time and comply with its terms.

For the seller, its main benefit is moving payment risk from the buyer to a bank. For the buyer, payment happens only when documents show the goods were shipped. International practice follows the ICC rules UCP 600.

The parties

Party	Role
Applicant	The buyer (importer) who asks its bank to open the credit.
Beneficiary	The seller (exporter) who will be paid.
Issuing bank	The buyer’s bank; it opens the credit and undertakes to pay if the terms are met.
Advising bank	A bank in the seller’s country that checks the credit is genuine and passes it to the seller.
Confirming bank	A bank that adds its own payment undertaking to the issuing bank’s. Confirmation removes the issuing bank and country risk from the seller.

How it works

1. Sales contract. The parties agree payment by letter of credit, its type, the documents and the deadlines.
2. Opening. The buyer applies to its bank, which opens the credit and sends it to a bank in the seller’s country.
3. Advice and review. The advising bank passes the credit to the seller, who checks every term at once and asks for amendments before shipment if needed.
4. Shipment and documents. The seller ships and prepares the documents the credit requires.
5. Presentation. Documents go to the bank before the presentation deadline and the expiry date.
6. Examination and payment. The bank examines the documents; if they comply, it pays at sight or at maturity. The documents go to the buyer, who collects the goods.

Types of letters of credit

Type	What it does
Confirmed / unconfirmed	In a confirmed credit, a second bank, usually in the seller’s country, also guarantees payment. Used when the buyer’s bank or country is a risk.
At sight	Payment when compliant documents are presented.
Deferred payment	Compliant documents are presented; payment follows at a set date.
Acceptance	A draft is presented with the documents; the bank accepts it and pays at maturity.
Negotiation	A nominated bank may pay early (discount) against compliant documents.
Transferable	The beneficiary can transfer all or part of the credit to another supplier; used by intermediaries.
Revolving	Renews itself over set periods, so regular shipments do not each need a new credit.
Back-to-back	An intermediary uses a credit opened in its favour to open a second one for its supplier.
Red clause	Allows an advance payment to the seller before shipment.

Risks for the exporter

• Discrepant documents: The most common reason for delayed payment. Every detail must match the credit exactly.
• Terms you cannot meet: A credit that requires a document controlled by the buyer, such as an inspection certificate signed by the buyer, puts payment in the buyer’s hands.
• Bank and country risk: If you are unsure of the issuing bank or its country, ask for confirmation.
• Deadlines: Latest shipment date, presentation period and expiry are linked; plan production and freight around them.

Frequently asked questions