Letter of Credit Explained: Types, Process, and Benefits

Letters of credit are one of the oldest and most reliable payment mechanisms in international trade. They provide security to both buyers and sellers in cross-border transactions by placing a bank at the centre of the deal. This guide covers everything you need to know about letters of credit, including how they work, the different types available, and when to use them.

What Is a Letter of Credit?

A letter of credit (LC) is a written commitment issued by a bank on behalf of a buyer (the applicant) guaranteeing payment to a seller (the beneficiary), provided the seller meets the terms and conditions specified in the LC. The bank effectively substitutes its own creditworthiness for that of the buyer.

In practice, this means the seller does not need to rely solely on the buyer’s promise to pay. Instead, the seller has a bank-backed guarantee that payment will be made upon presentation of compliant documents.

How Does a Letter of Credit Work?

The LC process typically follows these steps:

1. Agreement: The buyer and seller agree on the terms of the transaction, including the use of an LC as the payment method.
2. Application: The buyer applies to their bank (the issuing bank) for an LC in favour of the seller.
3. Issuance: The issuing bank reviews the buyer’s creditworthiness, approves the application, and issues the LC.
4. Advising: The LC is sent to a bank in the seller’s country (the advising bank), which authenticates it and notifies the seller.
5. Shipment: The seller ships the goods and prepares the required documents (bill of lading, commercial invoice, packing list, certificate of origin, etc.).
6. Presentation: The seller presents the documents to the advising or confirming bank.
7. Examination: The bank examines the documents for compliance with the LC terms.
8. Payment: If documents comply, the bank makes payment to the seller.
9. Reimbursement: The issuing bank reimburses the paying bank and debits the buyer’s account.

Types of Letters of Credit

Irrevocable Letter of Credit

The most common type. Once issued, it cannot be modified or cancelled without the agreement of all parties — the buyer, the seller, and the issuing bank. This provides the highest level of security for the seller.

Confirmed Letter of Credit

A confirmed LC carries a guarantee from a second bank (usually in the seller’s country) in addition to the issuing bank. This is particularly important when the seller has concerns about the issuing bank’s creditworthiness or the political and economic stability of the buyer’s country.

Standby Letter of Credit (SBLC)

Unlike a commercial LC, an SBLC serves as a backup guarantee. It is only drawn upon if the buyer fails to fulfil their payment obligations. SBLCs are commonly used in construction contracts, government tenders, and financial transactions.

Transferable Letter of Credit

This type allows the original beneficiary (the seller) to transfer all or part of the LC to a second beneficiary. It is commonly used by intermediaries and trading companies who source goods from manufacturers.

Back-to-Back Letter of Credit

Used when an intermediary is involved. Two separate LCs are issued — one from the buyer’s bank to the intermediary, and another from the intermediary’s bank to the actual supplier.

Revolving Letter of Credit

A revolving LC is designed for ongoing business relationships where multiple shipments are made over a period. Instead of opening a new LC for each shipment, the same LC is reinstated automatically after each drawing.

Key Documents Required

• Commercial invoice
• Bill of lading or airway bill
• Packing list
• Certificate of origin
• Insurance certificate
• Inspection certificate (if required)
• Customs documentation

Benefits of Letters of Credit

Benefit	For Buyer	For Seller
Payment Security	Payment only made when conditions are met	Guaranteed payment from a bank
Risk Reduction	Goods must be shipped before payment	Eliminates buyer default risk
Trade Facilitation	Access to international suppliers	Access to international markets
Financing	Can negotiate deferred payment terms	Can obtain pre-shipment financing

Common Pitfalls to Avoid

1. Document discrepancies: Even minor errors in documents can lead to rejection. Ensure all documents exactly match the LC terms.
2. Late presentation: Documents must be presented within the time frame specified in the LC. Late presentation is the most common reason for rejection.
3. Ambiguous terms: Vague or conflicting terms in the LC can cause disputes. Clarity is essential at the drafting stage.
4. Not understanding Incoterms: The LC terms should align with the agreed Incoterms (FOB, CIF, etc.) to avoid confusion over responsibilities.

When Should You Use a Letter of Credit?

• When trading with a new or unknown partner
• When dealing with politically or economically unstable regions
• When the transaction value is significant
• When the buyer cannot provide advance payment
• When the seller requires guaranteed payment before shipping

Conclusion

Letters of credit remain a cornerstone of international trade finance. They provide structured, bank-guaranteed security for both buyers and sellers, reducing the risks inherent in cross-border commerce. Whether you are an experienced trader or entering international markets for the first time, understanding how LCs work is essential for conducting business safely and efficiently.