Letter of Credit

A Letter of Credit (LC) is a financial instrument commonly used in international trade to ensure payment between buyers and sellers. It serves as a written undertaking by a bank, on behalf of the buyer (the importer), to pay the seller (the exporter) a specified amount, provided that the seller meets the terms and conditions set out in the letter. This mechanism reduces the risk of non-payment and builds trust between trading parties who may not be familiar with each other’s financial standing or legal systems.

Definition and Legal Framework

A Letter of Credit is a documentary credit issued by a bank at the request of its client (the applicant) in favour of a beneficiary (the exporter). It guarantees that payment will be made upon presentation of stipulated documents, such as invoices, shipping bills, and certificates of origin, which prove that goods have been shipped in accordance with the agreed contract.
The legal foundation for most Letters of Credit is provided by the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce (ICC). The UCP 600 standardises global practices and provides a common framework for banks, traders, and legal authorities to handle such transactions. In the United Kingdom and other Commonwealth jurisdictions, LCs are also governed by general principles of contract and banking law.

Parties Involved

A typical Letter of Credit transaction involves several key participants:

• Applicant (Buyer/Importer): The party who requests the issuing bank to open the LC in favour of the seller.
• Issuing Bank: The buyer’s bank that issues the LC and undertakes to make payment if the terms are met.
• Beneficiary (Seller/Exporter): The party in whose favour the LC is issued and who receives payment upon presenting compliant documents.
• Advising Bank: Usually located in the seller’s country, it notifies the beneficiary of the LC’s issuance and verifies its authenticity.
• Confirming Bank (optional): Adds its own payment guarantee, ensuring the seller receives payment even if the issuing bank or buyer defaults.
• Negotiating Bank (if applicable): Examines the documents presented by the exporter and negotiates payment or acceptance.

Process of Operation

The sequence of steps in a Letter of Credit transaction typically follows this pattern:

1. Sales Agreement: The buyer and seller agree on terms of sale, specifying payment by LC.
2. Issuance of LC: The buyer applies to their bank to issue an LC in favour of the seller, stating the terms and conditions.
3. Advising the Seller: The advising bank authenticates the LC and informs the exporter of its issuance.
4. Shipment of Goods: The seller dispatches goods as per the agreement and obtains necessary shipping and commercial documents.
5. Presentation of Documents: The exporter submits the required documents to the advising or negotiating bank.
6. Verification by Banks: The banks examine the documents strictly to ensure they comply with LC terms.
7. Payment or Acceptance: Once compliance is verified, the issuing or confirming bank releases payment to the exporter.
8. Reimbursement and Document Release: The buyer pays their bank, which then releases the shipping documents, allowing the buyer to take possession of the goods.

This system ensures that both parties fulfil their contractual obligations: the seller is assured of payment, and the buyer receives the agreed goods.

Types of Letters of Credit

Different forms of Letters of Credit cater to varied business requirements and levels of risk:

• Revocable Letter of Credit: Can be modified or cancelled by the issuing bank without prior notice to the seller (rarely used today).
• Irrevocable Letter of Credit: Cannot be altered or cancelled without the consent of all parties involved; the most common form under UCP 600.
• Confirmed Letter of Credit: A second bank (the confirming bank) adds its own guarantee to the LC, giving the seller additional security.
• Sight Letter of Credit: Payment is made immediately upon presentation and verification of compliant documents.
• Usance (or Term) Letter of Credit: Payment is deferred for a specified period after document presentation, allowing the buyer time to make arrangements.
• Standby Letter of Credit (SBLC): Acts as a secondary payment guarantee, invoked only if the buyer fails to fulfil their obligation.
• Revolving Letter of Credit: Used for ongoing shipments under long-term contracts, automatically replenishing the credit limit after each transaction.
• Transferable Letter of Credit: Allows the beneficiary to transfer part or all of the credit to another party, often used in intermediary trading.

Advantages and Disadvantages

Advantages for the Exporter:

• Guaranteed payment, reducing the risk of non-payment.
• Assured compliance through banks’ scrutiny of documents.
• Facilitates trade with unknown or distant buyers.

Advantages for the Importer:

• Payment is made only after proof of shipment and compliance with contractual terms.
• Enables negotiation of better trade terms and global partnerships.
• Builds trust and credibility in international transactions.

Disadvantages:

• High banking fees and administrative costs for issuance and confirmation.
• Strict documentary compliance required—minor discrepancies can lead to non-payment.
• Lengthy procedures and reliance on banks’ processing times.
• Possible exposure to political or currency risks in international markets.

Documents Required

The specific documents demanded under a Letter of Credit depend on the terms of the sales contract but generally include:

• Commercial Invoice – showing details of goods and prices.
• Bill of Lading – confirming shipment and ownership of goods.
• Insurance Certificate – covering the goods against risk during transit.
• Certificate of Origin – proving the country where goods were produced.
• Packing List – describing the contents, quantity, and packaging.
• Inspection Certificate – certifying the quality or condition of goods before shipment.

All documents must conform exactly to the LC requirements; discrepancies, however minor, can result in payment delays or rejection.

Legal and Practical Importance

Letters of Credit serve as vital instruments in international commerce, where transactions occur across legal systems, currencies, and political jurisdictions. They act as a bridge of trust between trading partners and form part of a broader system of documentary credits that underpin global trade finance.
The LC system supports exporters’ working capital needs and protects importers from the risk of paying for defective or non-delivered goods. For banks, it creates opportunities to earn fees and expand international banking services.
In modern trade, electronic and digital Letters of Credit are increasingly replacing traditional paper-based systems. The Uniform Rules for Digital Trade Transactions (URDTT), introduced by the ICC, aim to standardise these electronic credits, further streamlining global commerce.

Significance in International Trade

Letters of Credit remain a cornerstone of international trading practices, particularly for high-value or cross-border transactions involving parties without prior business relationships. They uphold the principle of documentary compliance—that payment depends solely on proper documentation, not on the actual condition of goods.