Letter of Credit

A Letter of Credit (L/C or LC) is a financial instrument issued by a bank (the "issuing bank") on behalf of a buyer, guaranteeing payment to a seller provided the seller presents specified documents proving that the goods have been shipped according to agreed terms. The letter of credit is the cornerstone of international trade finance — it solves the fundamental trust problem between buyers and sellers in different countries who may never have dealt with each other before.

How a Letter of Credit Works

The mechanics involve at least four parties:

1. Applicant (buyer/importer): Requests their bank to issue the LC in favor of the seller
2. Issuing bank: The buyer's bank, which underwrites the payment guarantee
3. Beneficiary (seller/exporter): The party who will receive payment upon presenting compliant documents
4. Advising/confirming bank: The seller's bank in their home country, which receives and authenticates the LC. If the bank "confirms" the LC, it adds its own payment guarantee, protecting the seller even if the issuing bank fails.

The process: Buyer and seller agree on terms → Buyer applies for LC → Issuing bank issues LC → LC is transmitted to seller via SWIFT → Seller ships goods and collects required documents → Seller presents documents to advising bank → Bank verifies documents → If compliant, payment is made.

Documentary Requirements

The power of an LC lies in the documents it requires. Common document requirements:

• Commercial invoice (exact quantities, prices, description matching LC)
• Full set of original negotiable Bills of Lading
• Packing list
• Certificate of Origin
• Insurance certificate (if CIF terms)
• Inspection certificate from named third-party inspector
• Certificate of Analysis (for chemicals, food)

Types of Letters of Credit

Revocable vs. Irrevocable: A revocable LC can be modified by the buyer without the seller's consent. In practice, virtually all commercial LCs are irrevocable — the issuing bank's obligation is firm once issued.

Confirmed LC: The advising bank adds its own payment guarantee. Essential when the issuing bank or country carries credit risk (e.g., import from a country with foreign exchange controls).

Sight LC vs. Usance LC (Deferred Payment): A sight LC pays immediately upon presentation of compliant documents. A usance LC gives the buyer a grace period (30, 60, 90, or 180 days) before payment — essentially providing financing.

Standby LC: Not used to pay for goods, but as a financial guarantee (similar to a bank guarantee or performance bond). Used in service contracts, real estate, and as a backstop for open account trade.

Documentary Compliance: The Strict Compliance Rule

Banks pay only against documents that are "strictly compliant" with LC terms. A minor typographical error — a missing comma, a shipment date one day outside the allowed window, a description not matching the LC exactly — can be grounds for a "discrepancy" rejection. Research suggests 60–70% of first-presentation document sets contain at least one discrepancy. Discrepancies cause delays and require buyer approval to waive.

This strict compliance requirement has driven the development of electronic letters of credit (eLCs) using platforms like Bolero, essDOCS, and Contour, which use digital documents that can be validated automatically.