what is letter of credit

Daniel Parker

3 min read

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12-03-2025

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A letter of credit (LC) is a financial instrument issued by a bank on behalf of a buyer (importer) that guarantees payment to a seller (exporter) for goods or services. It's essentially a promise from a bank to pay the seller, provided certain conditions are met. Letters of credit are widely used in international trade to mitigate risk for both buyers and sellers. This article will delve into the intricacies of what a letter of credit is, how it works, and its various types.

How Does a Letter of Credit Work?

Imagine you're an exporter in the US selling goods to an importer in Japan. You're understandably hesitant to ship your goods without assurance of payment. Similarly, the Japanese importer wants to ensure the goods meet specifications before releasing payment. A letter of credit bridges this gap.

Here's a simplified breakdown:

1. Importer (Buyer) applies to their bank: The importer approaches their bank and requests a letter of credit. They provide details about the transaction, including the amount, goods, and seller.

2. Bank issues the Letter of Credit: If approved, the bank issues a letter of credit, essentially guaranteeing payment to the exporter if the specified conditions are met. This commitment strengthens the importer's creditworthiness.

3. Exporter ships the goods: The exporter ships the goods, and simultaneously presents the required documents – such as an invoice, bill of lading, and certificate of origin – to their bank.

4. Bank verifies documents and pays the exporter: The exporter's bank verifies the documents against the terms of the letter of credit. If everything aligns, they release payment to the exporter.

5. Bank collects payment from the importer: The exporter's bank then collects payment from the importer's bank, completing the transaction.

Types of Letters of Credit

There are several types of letters of credit, each with its own nuances:

• Irrevocable Letter of Credit: This type cannot be amended or cancelled without the agreement of all parties involved. It offers the highest level of security for the exporter.

• Revocable Letter of Credit: This type can be amended or cancelled by the issuing bank at any time without the exporter's consent. It offers less security to the exporter. This type is rarely used.

• Confirmed Letter of Credit: Here, a second bank (usually the exporter's bank) confirms the letter of credit, adding an extra layer of security. This confirmation guarantees payment even if the issuing bank defaults.

• Unconfirmed Letter of Credit: The issuing bank is the sole guarantor of payment.

• Documentary Letter of Credit: This is the most common type. Payment is contingent upon the presentation of specified documents.

• Standby Letter of Credit: This type acts as a form of guarantee, usually in construction contracts. Payment is made only if a specified event occurs (like a breach of contract).

Advantages of Using a Letter of Credit

• Reduced Risk for Exporters: Payment is virtually guaranteed if the terms of the letter of credit are met.

• Reduced Risk for Importers: Payment is only released once the goods meet specified conditions.

• Enhanced Trust and Credibility: LCs foster trust and cooperation between parties, especially in international trade.

• Simplified International Transactions: They streamline complex international transactions by providing a clear framework.

Disadvantages of Using a Letter of Credit

• Cost: Letters of credit involve fees and charges from banks, adding to the overall transaction cost.

• Complexity: The process can be complex and time-consuming, requiring careful attention to detail.

• Documentation Requirements: Strict documentation requirements must be met to ensure payment.

• Potential Disputes: Disputes can arise if the documents don't meet the letter of credit's stipulations.

Conclusion

Letters of credit are powerful tools that facilitate secure international trade. By understanding their mechanics and various types, both importers and exporters can leverage them to minimize risk and ensure smooth transactions. The added security offered by a letter of credit often outweighs the costs involved, making it a valuable asset in global commerce. Remember to consult with your bank and legal counsel to determine the most suitable type of letter of credit for your specific transaction.