What is a Letter of Credit? A Comprehensive Guide


In the intricate web of international trade, where buyer and seller are often separated by vast distances and divergent regulatory systems, trust becomes paramount. Enter the ‘Letter of Credit’ – a critical financial tool that bridges this trust gap. Let’s delve deeper into understanding its dynamics.

Defining a Letter of Credit

A Letter of Credit (LC) is a commitment by a bank on behalf of a buyer that payment will be made to a seller provided that certain documentary delivery conditions have been met. In essence, it’s a safeguard, ensuring that all parties involved in the transaction fulfill their obligations.

Benefits in International Trade

  1. Guaranteed Payment: As long as the conditions of the LC are met, sellers are assured of payment.
  2. Buyer’s Assurance: The seller will only receive payment upon meeting specific conditions, ensuring the buyer gets what they’ve bargained for.
  3. Enhances Trust: LCs are especially useful when the trustworthiness of a trading partner is uncertain.

Types of Letters of Credit

  • Sight LCs: Payment is made immediately after the required documents are presented.
  • Usance or Time LCs: Provides a delay in payment, allowing the buyer time after receiving the goods.
  • Red Clause LCs: Partial advances are provided before shipment.
  • Revolving LCs: Designed for multiple shipments over a long period.

The Mechanics of a Letter of Credit

  • The buyer and seller agree on a sale, deciding to use an LC as a payment method.
  • The buyer approaches their bank to arrange the LC, specifying payment conditions.
  • The bank issues the LC and sends it to the seller’s bank.
  • The seller’s bank verifies and forwards it to the seller.
  • The seller ships the goods and presents the required shipping documents to their bank.
  • The bank checks the documents against the LC’s terms.
  • If everything matches, the bank processes the payment – either immediately or after an agreed period.

Key Parties Involved

  1. Applicant or Buyer: The person or entity who arranges for the issuance of the LC.
  2. Beneficiary or Seller: The recipient of the LC.
  3. Issuing Bank: The financial institution that creates and commits to the LC on behalf of the buyer.
  4. Advising Bank: Assists in communicating the LC to the beneficiary.

Typical Required Documents

While specific requirements can vary, commonly required documents include:

  • Commercial invoice
  • Bill of lading or airway bill
  • Packing list
  • Certificate of origin
  • Inspection certificate

Risks and Risk Mitigation

Despite the LC’s inherent structure to reduce risk, it’s not entirely devoid of them. For sellers, there’s the risk of document discrepancies leading to non-payment. Buyers, on the other hand, face the risk of the seller not shipping goods as described.

Mitigation lies in clear communication and thorough checking. Sellers should ensure that every document is meticulously prepared, matching the LC’s terms. Buyers can request document verification to ensure the shipped goods match their order.


A Letter of Credit serves as a beacon of trust in the complex realm of international trade, assuring both parties of clear, fair dealings. While it involves meticulous documentation and a clear understanding of its types and processes, its advantages in risk mitigation and fostering trust are unparalleled.

For those looking to dive deeper, resources like the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits provide an exhaustive look into the world of LCs.

Key Takeaways:

  1. A Letter of Credit is a bank’s guarantee of a buyer’s payment to a seller.
  2. It plays a pivotal role in enhancing trust in international trade.
  3. There are various types of LCs tailored for different trading needs.
  4. The process involves several parties, including buyer, seller, issuing bank, and advising bank.
  5. Precise documentation is crucial for the smooth execution of an LC.
  6. Though designed to mitigate risks, understanding potential pitfalls is essential for both buyers and sellers.

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