What is a “Letter of Credit”?

A Letter of Credit (LC) is essentially a document from a bank guaranteeing that a buyer’s payment to a seller will be received on time, for the correct amount and in the correct currency. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. An LC is a payment term typically used for long-distance and international commercial transactions and is a key instrument used by importers, exporters, and banks in Trade Finance. It is a way of reducing the payment risks associated with moving goods globally. Using documentary letters of credit allows the seller to significantly reduce the risk of non-payment for delivered goods.

Key Learning Points

  • A Letter of Credit is a document from a bank offering to guarantee that a buyer’s payment will be made on time, for the correct amount and in the correct currency
  • If the buyer does not make the payment then the bank is liable for the outstanding amount still owing
  • Essentially a bank is substituted as a source of payment and in return the bank collects a transaction fee and may also require collateral
  • Letters of credit are the foundation of International Trade Finance by providing a secure mechanism for payments on import/export without tying up cash resources
  • There are many different types of letters of credit including basic types (e.g. confirmed versus unconfirmed) and special types of Letters of Credit (e.g. Red Clause LC)
  • Payment for the goods shipped can be remitted to the seller’s bank or a large, reputable bank
  • Payment will only be made to the seller when the terms, conditions and required documentation of the Letter of credit are fully complied with

Letters of Credit Explained

Parties Involved in an LC Transaction

The typical LC process

When the seller has doubts about the credit-worthiness of the buyer or wants to ensure prompt payment, the seller can insist on payment by an irrevocable Letter of Credit. If the bank issuing the LC is unknown to the seller or if the seller is uncertain about a foreign issuing banks ability to honor its obligation, the seller can, with the approval of the issuing bank, request its own bank or a large international bank, to assume the risk of the issuing bank by confirming the letter of credit. Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit, as well as collecting a fee for the service, typically a percentage of the amount covered by the LC. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.

Example: Key Roles of all LC Parties

Below is a table with the key terms typically used in arranging a letter of credit.

Terms Definition Activity
Applicant Importer Buy
Beneficiary Exporter Sell
Issuing / Opening Bank Importer’s Bank Issues LC
Advising Bank Exporter’s Bank Advises LC
Confirming Bank Advising Bank / 3rd Party Bank Confirms LC
Paying Bank Any Bank as specified in LC Pays the Draft

The Applicant, the importer, needs the Letter of Credit in order to buy the goods. The Beneficiary, i.e. the exporter, sells the goods. The issuing or opening bank acts as the importer’s bank and issues the LC. The advising bank advises the seller on the LC. The confirming bank, often a 3rd party bank but sometimes also called advising bank typically confirms the LC. Depending on the situation the issuing bank, the advising bank or the confirming bank may pay the LC.

Selected Basic Types of Letters of Credit

Commercial Letter of Credit

A commercial letter of credit is a direct payment method in which the issuing bank makes the payments to the beneficiary. It is the most simple of the various types of letters of credit.

Revolving Letter of Credit

A revolving letter of credit is a single letter of credit that covers multiple transactions over a long period of time. It is used for regular transactions of the same commodity between the same buyer and the seller.

Confirmed vs. Unconfirmed Letter of Credit

The confirmed letter of credit refers to an additional guarantee to the original letter of credit obtained by a borrower from a second bank. This second letter guarantees that the second bank will pay the seller if the first bank fails to do so. The issuing bank in international transactions typically requests this arrangement.

Irrevocable vs. Revocable Letter of Credit

An irrevocable letter of credit very simply means that it can not be canceled or modified without the consent of the beneficiary. A letter of credit is deemed to be an irrevocable credit. The concept of a Revocable Credit was withdrawn in 2007.

Selected Special Types of Letters of Credit

In addition to basic Letters of Credit there is a wide range of special types of Letters of Credit including Red Clause Letter of Credit, Transferable Letter of Credit, Back-to-Back Letter of Credit, Deferred Payment Letter of Credit, Standby Letters of Credit and many more. If you are interested in Trade Finance, try to find out the special characteristics of these LC’s and take our online course in Trade Finance!