Letter of Credit
Bank guarantee ensuring a seller receives payment once specified documentary conditions are met.
A letter of credit (LC) is a financial instrument issued by a bank (the issuing bank) at the request of a buyer (the applicant) guaranteeing payment to a seller (the beneficiary) upon presentation of specified documents proving the seller has met the agreed contractual conditions—typically shipment of goods, submission of invoices, and compliance with shipping terms. Letters of credit are foundational instruments in international trade finance, addressing the fundamental trust problem when buyers and sellers are in different countries with different legal systems.
The most common type is a documentary letter of credit: the seller ships goods, collects required documents (commercial invoice, bill of lading, certificate of origin, inspection certificate), and presents them to their local bank (the advising bank), which forwards them to the issuing bank. If documents comply with LC terms, the issuing bank pays the seller—regardless of whether the buyer has paid the bank. The bank's credit substitutes for the buyer's creditworthiness.
Variants include: irrevocable LC (cannot be amended without beneficiary consent—the standard type), confirmed LC (a second bank adds its guarantee, protecting against issuing bank country risk), standby LC (a guarantee of payment if the buyer fails to pay directly—used more like a performance bond), revolving LC (refreshes automatically for multiple shipments), and red clause LC (allows advance payment before shipment).
Standby letters of credit are widely used in commercial real estate leases (landlords require them from tenants as security deposits), construction projects, utility deposits, and financial guarantees.
Letter of credit fees include issuance fees (0.25–1.5% of LC value), advising fees, confirmation fees, and amendment fees.
FAQs
What documents are typically required under a letter of credit?
Required documents vary by transaction but commonly include: a commercial invoice (describing goods, value, and buyer/seller), a bill of lading or airway bill (proof of shipment from carrier), a certificate of origin (certifying where goods were produced), a packing list, an inspection certificate from an independent third-party inspector, an insurance certificate (for CIF-term transactions), and the original LC itself. Banks examine documents strictly against LC terms—even minor discrepancies (spelling errors, incorrect dates, different product descriptions) can constitute a discrepancy, allowing the bank to refuse payment until corrected.
What is the difference between a documentary LC and a standby LC?
A documentary letter of credit is the primary payment mechanism in a trade transaction—payment is expected to occur through the LC in the normal course of business when the seller presents complying documents. A standby letter of credit is a secondary payment mechanism, functioning as a guarantee—it is only drawn upon if the buyer defaults on their primary payment obligation (such as failing to pay an invoice directly). Standby LCs are more like performance bonds or security deposits and are not intended to be the primary settlement method. Documentary LCs are common in international goods trade; standby LCs appear in real estate leases, construction contracts, and utility deposits.
How does a confirmed letter of credit protect the seller?
A confirmed letter of credit adds a second payment guarantee from a bank in the seller's country (the confirming bank) in addition to the issuing bank's guarantee. This protects the seller against two risks: first, the risk that the issuing bank fails or becomes insolvent before payment; second, country risk—the risk that the government of the buyer's country imposes currency controls, sanctions, or restrictions preventing payment even if the issuing bank is willing to pay. With confirmation, the seller's local bank commits to pay regardless of what happens in the buyer's country, providing full payment certainty.
Related Terms
Standby Letter of Credit
Bank guarantee drawn only if an obligor fails to fulfill a contractual or financial obligation.
Factoring
Selling accounts receivable to a third party at a discount in exchange for immediate cash.
Asset-Based Lending
Commercial lending facility secured by specific business assets, typically receivables and inventory.
SWIFT Code
Unique identifier (BIC) for financial institutions used in international wire transfers.
