In international trade, the buyer and seller often sit in different countries, under different legal systems, having never met. The fundamental question is: how does the seller get paid, and how does the buyer ensure they receive what they ordered? The letter of credit is the instrument that has answered this question for centuries. Here is a complete, practical breakdown of how it works, the different types, and when to use it.
The Problem Trade Finance Solves
Cross-border trade carries a built-in tension. The seller does not want to ship goods before being sure of payment. The buyer does not want to pay before being sure of the goods. Trade finance instruments bridge that gap by inserting trusted intermediaries — usually banks — that guarantee performance on both sides.
What a Letter of Credit Is
A letter of credit (LC) is a commitment by the buyer’s bank (the issuing bank) to pay the seller, provided the seller presents documents proving the agreed terms have been met. The bank’s creditworthiness replaces reliance on the buyer’s. The seller ships knowing payment is guaranteed against compliant documents; the buyer pays knowing the goods were shipped as specified.
How a Letter of Credit Works, Step by Step
- Contract agreement. Buyer and seller agree in the sales contract that payment will be made via letter of credit, and agree the key terms.
- LC application. The buyer applies to their bank (the issuing bank) to open the letter of credit in the seller’s favor, specifying the exact documents required and the deadline.
- LC issuance and advising. The issuing bank sends the letter of credit to a bank in the seller’s country (the advising bank), which verifies its authenticity and notifies the seller.
- Shipment. The seller ships the goods according to the agreed terms and Incoterm.
- Document presentation. The seller presents the required documents — typically the commercial invoice, transport document (such as a bill of lading), packing list, and certificate of origin — to the advising or nominated bank, within the deadline stated in the LC.
- Document examination. The bank examines the documents strictly against the LC’s terms. This is why accurate export documentation matters so much: under a letter of credit, the documents — not the physical goods — are what trigger payment.
- Payment. If the documents comply exactly, the bank pays (or accepts a deferred payment obligation, depending on the LC type). If there are discrepancies, payment can be delayed, refused, or made subject to the buyer’s separate waiver of the discrepancy.
Types of Letters of Credit
Irrevocable vs revocable. Virtually all letters of credit used today are irrevocable, meaning they cannot be changed or cancelled without the agreement of all parties — this is what gives the seller real payment security. Revocable LCs offer little protection and are rarely used.
Confirmed vs unconfirmed. An unconfirmed LC relies solely on the issuing bank’s commitment. A confirmed LC adds a second guarantee from a bank in the seller’s own country (the confirming bank), which is valuable when the seller has doubts about the issuing bank’s creditworthiness or the political and banking stability of the buyer’s country.
Sight vs usance (deferred payment). A sight LC pays immediately once compliant documents are presented. A usance LC specifies payment at a future date after presentation (e.g. 60 or 90 days), effectively giving the buyer a short-term credit period while still giving the seller a guaranteed, dated payment commitment.
Standby letter of credit. Functions more like a bank guarantee than a payment mechanism — it is only drawn upon if the buyer fails to pay through the normal agreed method, acting as a backstop rather than the primary payment route.
When to Use a Letter of Credit
Letters of credit make most sense when trading with a new counterparty you do not yet trust fully, when dealing in large transaction values, when entering an unfamiliar market with limited legal recourse, or when the cost of non-payment would be severe. For established relationships with proven reliability, simpler and cheaper payment terms are often appropriate — the security an LC provides comes at a real cost in bank fees and administrative complexity.
What Discrepancies Actually Mean in Practice
A large share of letters of credit are presented with at least one document discrepancy on first submission — a misspelled company name, a bill of lading dated after the LC’s shipment deadline, a quantity that doesn’t precisely match the invoice. Banks examine documents strictly on their face, not on whether the underlying shipment was genuinely fine, so even a minor clerical mismatch can trigger a discrepancy notice. This is resolvable — the buyer can waive the discrepancy, or documents can be corrected and re-presented within the LC’s validity period — but it causes delay, which is why getting documentation right the first time matters more under an LC than under almost any other payment method.
Costs to Expect
Letter of credit costs typically include an issuance fee charged to the buyer (often a percentage of the LC value), an advising fee for the seller’s bank, and, if applicable, a confirmation fee for a confirming bank — confirmation fees vary considerably based on the issuing bank’s perceived risk. These costs should be factored into pricing decisions when an LC is required, particularly for lower-margin commodity trades where bank fees can meaningfully affect profitability.
Other Trade Finance Tools
Letters of credit are the best known, but not the only option:
- Documentary collections — a lighter, lower-cost middle ground where banks handle document exchange but do not guarantee payment, relying instead on the buyer’s willingness to pay against documents.
- Bank guarantees — secure performance obligations rather than payment itself, commonly used alongside other payment terms for large contracts.
- Open account terms — the seller ships and invoices, trusting the buyer to pay per agreed terms; suits established, trusted relationships with no real payment security built in.
Choosing the right instrument is a balance of security against cost and speed — more security generally means more cost and more procedural friction.
Frequently Asked Questions About Letters of Credit
What is the difference between a confirmed and unconfirmed letter of credit?
An unconfirmed LC relies solely on the issuing bank’s payment commitment. A confirmed LC adds a second guarantee from a bank in the seller’s own country, providing extra security when the seller has doubts about the issuing bank or the buyer’s country risk.
What happens if there is a discrepancy in the documents presented under a letter of credit?
The bank can refuse payment, delay it pending the buyer’s waiver of the discrepancy, or the seller can correct and re-present the documents within the LC’s validity period. Discrepancies are common and usually resolvable, but they cause delay.
Who pays the fees for a letter of credit?
Typically the buyer pays the issuance fee to the issuing bank, and the seller pays the advising fee (and confirmation fee, if applicable) to their own bank, though this can be negotiated and specified differently in the sales contract.
What is a standby letter of credit?
A standby letter of credit functions like a bank guarantee rather than a primary payment method — it is only drawn upon if the buyer fails to pay through the normal agreed payment method, acting as a backstop rather than the main transaction mechanism.
Is a letter of credit always the safest payment method?
It is one of the more secure methods for the seller, but it comes with real costs in bank fees and procedural complexity, and strict document compliance requirements. For trusted, established relationships, simpler and cheaper terms like open account are often more appropriate.
Navigating Trade Finance With Confidence
Choosing and structuring the right payment mechanism is part of getting a cross-border transaction right, especially in newer markets across Central Asia and the GCC. Our advisory services help structure trade transactions end to end. Book a discovery call to discuss yours.
This article is general information, not financial or legal advice. Always consult qualified banking and legal professionals for your specific transaction.