A letter of credit solves an old problem. A seller does not want to release several hundred tonnes of steel to a buyer on the other side of the world before being paid. The buyer does not want to pay before there is any evidence the steel exists or has shipped. Neither has a reason to go first.
A letter of credit puts a bank between them. The bank undertakes to pay the seller, provided the seller presents documents that comply exactly with what the credit demands. Trust in the counterparty is replaced by trust in a bank and in a set of documents.
The Parties
- Applicant — the buyer, who asks their bank to open the credit.
- Issuing bank — the buyer’s bank, which issues the credit and carries the obligation to pay.
- Advising bank — a bank in the seller’s country that passes the credit on and confirms it is genuine.
- Confirming bank — where the credit is confirmed, a second bank adds its own independent undertaking to pay.
- Beneficiary — the seller, who gets paid on presenting compliant documents.
How It Runs
- Buyer and seller agree the sale and that payment will be by letter of credit.
- The buyer applies to their bank, which issues the credit and sends it to the advising bank.
- The seller receives the credit and checks it against the contract. This step is frequently rushed and should not be.
- The seller ships the goods and assembles the document set.
- The documents are presented to the bank within the presentation period.
- The bank examines them. If they comply, payment is made at sight or at the agreed future date.
- Documents are released to the buyer, who uses the bill of lading to take delivery.
The Types You Will Meet
- Irrevocable — cannot be amended or cancelled without everyone’s agreement. Under current practice all credits are irrevocable unless stated otherwise.
- Confirmed — a second bank adds its own undertaking. Worth paying for where the issuing bank or its country carries risk the seller is unwilling to take.
- Sight — payment on presentation of compliant documents.
- Usance or deferred — payment at a stated period after shipment or presentation, commonly 30, 60 or 90 days. This is how credit terms are extended without the seller carrying the buyer’s risk directly.
- Transferable — allows the beneficiary to transfer part or all of the credit to a supplier further up the chain.
The Documents
A steel credit typically calls for a set close to this:
- Commercial invoice
- Full set of clean on-board bills of lading
- Packing list
- Mill test certificates
- Certificate of origin
- Insurance certificate, where the Incoterm requires the seller to insure
- Inspection certificate, where one is specified
- Beneficiary’s certificate confirming documents were sent as required
Discrepancies: Where Letters of Credit Actually Go Wrong
Banks deal in documents, not in goods. This is the principle that makes the instrument work and also the one that catches people out. If the steel is perfect and the documents are not, the bank is entitled to refuse; if the documents comply, the bank pays regardless of what is in the hold.
A discrepancy is any inconsistency between the documents and the credit, or between the documents themselves. A significant proportion of first presentations are rejected, almost always for avoidable reasons:
- Description of goods on the invoice not matching the wording of the credit.
- Documents presented after the presentation period, or after the credit expired.
- Shipment after the latest shipment date.
- Weights, quantities or marks that disagree between the packing list, the invoice and the bill of lading.
- A bill of lading that is claused rather than clean, or not marked on board.
- A missing document, or one not signed or certified in the manner the credit specifies.
Discrepancies are usually resolved — the buyer waives them, or documents are corrected and re-presented — but each round costs days and a fee, and in a falling market a buyer has an incentive to be unhelpful about it.
The Rulebook
Documentary credits are governed by the ICC’s UCP 600, which almost every credit incorporates by reference. It sets out how banks examine documents, what counts as compliant, and the time limits involved. When a bank rejects a presentation, UCP 600 is the framework the argument is conducted in.
When an LC Is Worth It
A letter of credit carries real cost — issuance and confirmation fees, plus the working capital the buyer ties up — and real administrative effort. It earns that where the counterparty is new or unrated, where the country risk is meaningful, where the cargo value is large relative to what either side can absorb losing, or where the seller needs the certainty in order to fund the purchase.
Where a trading relationship is long-standing and the credit position is understood, simpler mechanisms such as cash against documents or open account terms cost far less and move far faster.
The Short Version
A letter of credit is a bank’s conditional promise to pay against documents. The goods are not the bank’s concern; the paperwork is. Check the credit against the contract the day it arrives, make sure every date and description is achievable, and prepare the documents to match the wording exactly rather than approximately.
If you want to discuss payment structures on a particular transaction, get in touch.
This article is general explanation, not financial or legal advice.
Related reading: the documents a credit calls for are produced along the journey from mill to site, and the Incoterm agreed determines who is responsible for several of them — see Incoterms.