How a documentary letter of credit works, who the parties are, what it costs you in effort, and how first-time importers can avoid document discrepancies.
5 min read
A letter of credit solves an old problem in international trade. The seller does not want to ship before being sure of payment. The buyer does not want to pay before being sure the goods have shipped. A letter of credit puts a bank between them.
This guide explains how a letter of credit works from the importer's side. It is general information, not financial or legal advice. Fees, requirements and procedures differ from bank to bank, so discuss any real transaction with your own bank.
What a letter of credit is
A documentary letter of credit, often shortened to LC or L/C, is a written undertaking by a bank, given at the buyer's request, to pay the seller a stated amount, provided the seller presents the documents listed in the credit, in the required form and within the stated time.
Two ideas explain most of how it behaves:
- Banks deal with documents, not goods. The bank checks whether the documents match the credit. It does not inspect the cargo.
- The credit is separate from the sales contract. The bank's obligation depends on the credit's terms, even if buyer and seller later disagree about the contract.
Most commercial letters of credit state that they are subject to UCP 600, the International Chamber of Commerce's rules for documentary credits.
Who is involved
| Party | Role |
|---|---|
| Applicant | The buyer, who asks the bank to issue the credit |
| Issuing bank | The buyer's bank, which gives the undertaking to pay |
| Beneficiary | The seller, who is paid against compliant documents |
| Advising bank | A bank in the seller's country that passes on the credit and confirms it is authentic |
| Confirming bank | A bank that adds its own undertaking to pay, if the seller requests confirmation |
How it works, step by step
- Contract. Buyer and seller agree the sale and that payment will be by letter of credit. They should also agree the main terms of the credit at this stage.
- Application. The buyer applies to its bank.
- Issue. The issuing bank sends the credit to the advising bank, which forwards it to the seller.
- Review. The seller checks that every term can be met. If not, the seller asks the buyer for an amendment before shipping.
- Shipment. The seller ships the goods and collects the documents.
- Presentation. The seller presents the documents to the bank within the time allowed.
- Examination. The banks check the documents against the credit. Under UCP 600 a bank has up to five banking days after presentation to decide whether the documents comply.
- Payment. If the documents comply, the seller is paid, either immediately or at the agreed later date.
- Release. The issuing bank passes the documents to the buyer against payment or the buyer's agreed obligation to pay. The buyer uses them to collect the goods.
Common types
- Sight credit. Payment is made once compliant documents are presented and checked.
- Usance or deferred payment credit. Payment falls due a set period later, for example a number of days after the bill of lading date. This gives the buyer time to receive and sell the goods.
- Confirmed credit. A second bank, usually in the seller's country, adds its own promise to pay. Sellers ask for this when they are unsure about the issuing bank or the country risk.
Documents a credit usually asks for
- Commercial invoice
- Transport document, such as a bill of lading
- Packing list
- Insurance document, when the seller is responsible for insurance, for example under CIF
- Certificate of origin
- Inspection or quality certificate, if the buyer requires one
Our export documents checklist describes each of these.
What a letter of credit does and does not protect
For the seller, a credit replaces the buyer's promise to pay with a bank's promise, as long as the documents are correct.
For the buyer, a credit means payment is made only after documents show that goods were shipped on time and as described on paper. It does not guarantee the quality of what is inside the container. If quality matters, require an inspection certificate from an independent inspector as one of the documents. See our guide to pre-shipment inspection.
Discrepancies: where most problems arise
A discrepancy is any difference between the documents and the credit, or between one document and another. Typical examples:
- Shipment after the latest shipment date, or presentation after the credit has expired.
- Documents presented too late after shipment. Under UCP 600, transport documents must be presented within 21 calendar days of shipment unless the credit says otherwise, and always before expiry.
- A goods description on the invoice that does not correspond with the credit.
- Company names, addresses, weights or quantities that conflict between documents.
- A missing document, signature or endorsement.
When documents are discrepant, the bank is no longer bound to pay. The buyer is asked whether to accept the discrepancy, which usually means fees and delay.
Practical tips for importers
- Agree the credit terms in the sales contract, including the list of documents, latest shipment date, expiry date and place, and whether partial shipments and transhipment are allowed.
- Send the seller a draft of the application before the bank issues it. Amendments after issue cost time and money.
- Ask your bank for all fees in advance, including charges outside your country and who pays them.
Is a letter of credit right for your order?
A credit adds cost and paperwork, so it is most useful when the order is large, the parties are new to each other, or the seller requires bank security. For smaller or repeat orders, other methods may fit better. Our overview of payment terms in international trade compares the options.
If you are planning an order and want to discuss terms, request a quote and tell us the product, quantity, destination and your preferred payment method.
This article is general guidance, not legal, tax or customs advice. Rules change; confirm requirements for your shipment with the relevant authorities.
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