Letters of Credit, Functions, Types, Process

Letter of Credit (LC) is a written commitment issued by a bank on behalf of a buyer, guaranteeing payment to a seller upon the fulfillment of specific terms and conditions—usually the delivery of goods or services. It acts as a risk-reducing financial instrument in international trade, assuring the exporter that payment will be made if the shipping documents comply with the terms mentioned in the LC. It is commonly used when buyers and sellers are in different countries and do not know each other well.

The bank issuing the LC (issuing bank) works with the seller’s bank (advising or negotiating bank) to verify documents such as the bill of lading, invoice, insurance papers, and inspection certificates. Once the seller submits compliant documents, the bank releases the payment. Letters of Credit help eliminate credit risk, currency issues, and trust gaps, making them essential in global trade for ensuring timely and guaranteed payments between unfamiliar parties in cross-border transactions.

Functions of Letters of Credit:

  • Ensures Payment Security in Trade

The primary function of a Letter of Credit is to guarantee payment to the seller upon fulfillment of specific terms. It eliminates the risk of buyer default by shifting the payment responsibility to a reliable bank. Once the seller submits the required documents proving shipment, the bank is obligated to pay, regardless of the buyer’s financial status. This function provides confidence to exporters, encouraging international trade by ensuring that sellers are paid promptly and securely.

  • Builds Trust Between Unfamiliar Parties

In international or long-distance trade, buyers and sellers often operate across borders without prior relationships. Letters of Credit act as trust-building instruments, assuring the seller that the buyer has a bank backing their payment. It also assures the buyer that payment will only be made if the seller complies with the agreed terms. This mutual protection creates a neutral and legally binding mechanism, reducing hesitation in cross-border deals and enabling smoother global commerce.

  • Reduces Credit Risk for Sellers

Letters of Credit mitigate credit risk by transferring it from the buyer to a financial institution. The seller does not have to depend solely on the buyer’s creditworthiness. Instead, the seller relies on the issuing bank’s obligation to pay. This reduces the fear of non-payment or delayed payment, especially in cases where the buyer is in a politically or economically unstable country. For exporters, this function adds a level of financial security that supports international business expansion.

  • Facilitates Financing for Trade

LCs also function as a financing tool for both exporters and importers. Sellers can use the LC as collateral to obtain pre-shipment or post-shipment finance from their bank. Importers may get credit terms through a Usance LC, allowing deferred payment. This facilitates better cash flow management for both parties. LCs also enable traders to structure complex deals, such as transferable or back-to-back credits, helping intermediaries and suppliers secure funding based on assured future payments.

  • Ensures Compliance Through Document Control

A key function of LCs is to ensure that trade documentation is complete and accurate before payment is released. The seller must provide documents like bills of lading, invoices, insurance certificates, and inspection reports, all matching the LC terms. The bank verifies these meticulously before making payment. This function enforces discipline and legal compliance, protecting both the buyer and the bank, and ensuring that goods are shipped as agreed before money changes hands.

  • Encourages International Trade Growth

By reducing payment uncertainty, enforcing trade conditions, and providing financial assurance, LCs play a crucial role in boosting international trade. They make it easier for companies to do business with new partners across borders, overcoming language, legal, and currency barriers. The use of LCs fosters smoother global transactions and promotes economic integration. For many businesses, especially exporters in developing economies, LCs serve as critical enablers of trade, ensuring business continuity and market expansion.

Types of Letters of Credit:

  • Revocable Letter of Credit

Revocable Letter of Credit allows the issuing bank to modify or cancel the LC at any time without prior notice to the beneficiary (seller). This type offers minimal protection to the seller, as the guarantee can be withdrawn even after shipment. Due to its high risk for exporters, revocable LCs are rarely used in international trade. They may be suitable only for domestic or highly trusted transactions, where the buyer and seller have a long-standing relationship.

  • Irrevocable Letter of Credit

An Irrevocable LC cannot be altered or cancelled without the agreement of all parties involved, including the beneficiary. It provides strong security to the seller, as the issuing bank is obligated to honor payment if compliant documents are submitted. Most LCs used in global trade today are irrevocable. This type ensures that sellers can ship goods with confidence, knowing that payment is guaranteed, provided they meet all terms specified in the LC.

  • Confirmed Letter of Credit

Confirmed Letter of Credit includes a second guarantee from another bank—usually the advising bank—along with the issuing bank. This added confirmation is requested when the seller does not trust the issuing bank or when the buyer is in a country with political or economic instability. The confirming bank takes on the responsibility to pay, even if the issuing bank defaults. This provides an additional layer of security to exporters and is often used in high-risk markets.

  • Unconfirmed Letter of Credit

An Unconfirmed LC is only backed by the issuing bank, with no obligation on the advising bank. If the issuing bank fails to honor the payment, the seller must take legal steps against it. This is more common when both buyer and issuing bank are based in stable economies and the seller is confident in their credibility. While it involves lower costs, it offers less security than a confirmed LC, making it less attractive in high-risk transactions.

  • Sight Letter of Credit

Sight LC is payable immediately upon presentation of compliant documents. Once the seller submits the required documents to the advising bank and they are verified, payment is made “at sight”, meaning on the spot or within a short period (typically 2–7 days). This is beneficial for sellers who need quick access to funds and is commonly used in trade where goods are shipped immediately, and cash flow is essential for ongoing business operations.

  • Usance (Deferred Payment) Letter of Credit

Usance LC or Deferred Payment LC allows for payment to be made at a future date after the documents are submitted. The time period (30, 60, or 90 days) is agreed upon in advance. This benefits the buyer by providing short-term credit to arrange funds, while the seller gets assurance of future payment from the issuing bank. It is ideal for large transactions, where buyers need time to resell goods before making full payment.

  • Transferable Letter of Credit

Transferable LC allows the original beneficiary (usually a middleman or trader) to transfer a portion or full value of the credit to another party (like a supplier). This is useful in cases where the beneficiary is not the actual manufacturer but wants to fulfill the order through a third party. It facilitates back-to-back trade deals and enables financing of transactions without upfront capital. Only LCs clearly marked as “transferable” can be legally passed on to others.

  • Back-to-Back Letter of Credit

Back-to-Back LC involves two separate LCs: the first is issued in favor of an intermediary (trader), and the second is issued by the intermediary’s bank to the final supplier, using the first LC as security. This type is used when the intermediary doesn’t have enough credit or capital but wants to facilitate the transaction between buyer and supplier. It supports complex trade chains and allows smooth execution of orders without involving direct financial exposure.

Process of Letters of Credit:

1. Buyer and Seller Agree on LC Terms

The process begins when the buyer and seller agree to use a Letter of Credit as the payment method in their contract. They define the LC terms, including the amount, shipment date, required documents, and conditions for payment. The buyer then contacts their bank (issuing bank) to initiate the LC. This agreement ensures both parties are aware of their obligations and that the seller is protected against payment risks, especially in international trade.

2. Buyer Requests LC from Issuing Bank

The buyer approaches their bank and formally requests the issuance of the LC in favor of the seller (beneficiary). The issuing bank reviews the buyer’s creditworthiness, may require a margin or security, and then issues the LC. The LC outlines all terms such as amount, expiry, document requirements, and conditions for payment. It serves as a payment guarantee from the issuing bank, giving the seller assurance that payment will be made upon fulfilling the conditions.

3. Issuing Bank Sends LC to Advising Bank

Once the LC is issued, the issuing bank forwards it to the seller’s bank (advising bank), usually located in the seller’s country. The advising bank authenticates the LC, ensuring its legitimacy, and notifies the seller about the receipt of the LC. It does not take on any payment obligation but acts as an intermediary for communication. This step assures the seller that the payment is backed by a reputable financial institution and that trade can proceed safely.

4. Seller Ships Goods and Submits Documents

The seller, after receiving and reviewing the LC, ships the goods as per the agreed terms. They then prepare and submit the required shipping and commercial documents (e.g., invoice, bill of lading, packing list, insurance certificate) to the advising or negotiating bank. These documents must strictly comply with the LC terms. This step ensures that the seller has fulfilled their contractual obligations and is now eligible to receive payment upon document verification.

5. Advising Bank Forwards Documents to Issuing Bank

The advising or negotiating bank checks the documents for discrepancies. If everything is in order, it forwards the documents to the issuing bank for final scrutiny. Some advising banks may also make payment or advance funds if they confirm the LC. The issuing bank then verifies whether the documents meet all the LC conditions. If compliant, the bank proceeds to make or authorize the payment to the seller, ensuring secure transfer of funds.

6. Payment is Made and Buyer Receives Goods

Upon successful verification, the issuing bank releases payment to the seller through the advising or negotiating bank. The issuing bank then forwards the original shipping documents to the buyer, who uses them to clear the goods at port or customs. The transaction is now complete. This final step ensures that the seller is paid and the buyer gains access to the goods, fulfilling the purpose of the Letter of Credit as a secure payment method in international trade.

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