Letter of Credit: Meaning, Types, Process and How It Works

A Letter of Credit (LC) is a financial instrument used to reduce payment risk in trade transactions. Being aware of the meaning of a Letter of Credit is important for any business involved in domestic or international trade. It gives both the buyer and seller confidence that payment will be made once the agreed conditions are met. Commonly used in cross-border and high-value transactions, it helps build trust between parties who may not have worked together before.

What Is a Letter of Credit?

A Letter of Credit is a financial institution’s written commitment to pay the seller a specified amount on behalf of the buyer, provided that the agreed-upon documents and conditions are fulfilled. A Letter of Credit in banking acts as a payment assurance mechanism that shifts payment risk from the seller to the issuing institution.

Here is the Letter of Credit's meaning in practical terms: The financial institution acts as a trusted intermediary, ensuring the seller receives payment upon document compliance, while the buyer is protected through predefined terms. It is one of the most widely used instruments in trade finance globally.

How Much Does a Letter of Credit Cost

Determining the cost of a Letter of Credit (LC) involves understanding the various charges associated with this financial instrument. The primary fees include issuance fees, advising fees, and confirmation fees.

The issuing bank typically charges an upfront issuance fee for preparing and issuing the LC. Additionally, if the buyer's bank seeks the expertise of another bank (confirming bank) to add confirmation, an additional confirmation fee may apply. Advising fees are charged by the advising bank for verifying and forwarding the LC to the seller. Furthermore, there are amendment fees if any changes are made to the original LC terms. It's essential to consider negotiation fees, which the seller's bank may charge for reviewing and negotiating the documents. The buyer bears these costs, but they are essential for ensuring a smooth and secure transaction process. Additionally, the parties involved should be aware of discrepancy fees if the presented documents do not align with the LC terms. While these costs contribute to the overall expense, the reliability and security provided by an LC often justify the investment, especially in complex international trade scenarios.

How a Letter of Credit Works

In the LC process, the buyer's financial institution issues a formal payment commitment to the seller, based on conditions agreed between both parties. The Letter of Credit process begins when a buyer and seller agree on trade terms, and the buyer requests their financial institution to issue an LC in favour of the seller.

The seller then ships the goods and submits the required documents. The financial institution examines these documents to ensure they strictly comply with the LC terms before releasing payment. This structured approach protects both parties and ensures that funds are transferred only when all conditions are met.

Step-by-Step Letter of Credit Process

The steps in the Letter of Credit process are straightforward when broken down clearly.

1. Buyer and seller agree on trade terms, including payment method, goods, and delivery conditions.
2. Buyer applies for an LC with their financial institution, known as the issuing bank, providing transaction details.
3. The issuing bank sends the LC to the seller's financial institution, known as the advising bank, confirming the payment commitment.
4. Seller ships the goods in accordance with the terms specified in the LC.
5. Seller submits the required documents to their bank, such as the bill of lading, invoice, and certificate of origin.
6. Bank checks compliance by verifying that all submitted documents match the LC terms precisely.
7. Payment is released to the seller once all documents are confirmed as compliant.

This concludes the LC transaction steps.

Parties Involved in a Letter of Credit

Each LC party plays a specific role in ensuring the transaction is secure, compliant, and completed smoothly. The Letter of Credit participants work together to create a structured and trusted payment environment for both buyer and seller.

Applicant: The buyer who initiates the LC process. They approach their bank to issue the Letter of Credit in favour of the seller and are responsible for ensuring the LC terms reflect the agreed trade conditions. The applicant is also responsible for reimbursing the issuing bank once payment is released.

Beneficiary: The beneficiary is the seller or exporter who receives the payment guarantee through the LC. They must comply with all conditions stated in the LC and submit the required documents within the specified timeframe to receive payment. The beneficiary is the primary party protected by the LC structure.

Issuing Bank: This is the buyer's bank that creates and issues the Letter of Credit. It takes on the payment obligation on behalf of the buyer, committing to pay the beneficiary once the compliant documents are presented. The issuing bank carries the primary financial responsibility in the transaction.

Advising Bank: The advising bank is typically located in the seller's country and is responsible for notifying the beneficiary that an LC has been issued in their favour. It verifies the authenticity of the LC and passes it on to the seller without taking on any payment obligation itself.

Confirming Bank: A confirming bank adds its own payment guarantee to the LC, in addition to that of the issuing bank. This is used when the seller requires extra assurance, particularly when there is uncertainty about the issuing bank’s reliability or the buyer's country risk. The confirming bank takes on direct payment responsibility to the seller.

Negotiating Bank: The negotiating bank examines the documents submitted by the seller and, if they are compliant, advances payment to the seller before receiving funds from the issuing bank. This provides the seller with faster access to funds and reduces the time between shipment and payment.

Letter of Credit Process Overview

Step	Party Involved	Action
1. Trade agreement	Buyer and Seller	Agree on terms, price, and payment method
2. LC application	Applicant (Buyer)	Applies to the issuing bank to open the LC
3. LC issuance	Issuing Bank	Issues and sends LC to the advising bank
4. LC notification	Advising Bank	Notifies the seller and authenticates the LC
5. Shipment	Beneficiary (Seller)	Ships goods and prepares required documents
6. Document submission	Beneficiary and Negotiating Bank	Submits documents for payment claim
7. Document verification	Issuing Bank	Checks for document compliance against LC terms
8. Payment release	Issuing Bank	Releases payment to the seller or negotiating bank

Types of Letter of Credit

Here is an overview of the different types of letters of credit most commonly used in trade finance.

These LC types are typically categorised based on factors such as trade structure, payment timing, and risk profile.

Commercial Letter of Credit

A commercial Letter of Credit is the standard LC used for payment in trade transactions. The commercial LC's meaning is simply that it serves as the primary payment mechanism between buyer and seller, with the bank committing to pay the seller directly once compliant documents are presented. It is the most widely used form of trade payment LC, in both domestic and international commerce.

Confirmed Letter of Credit

A confirmed Letter of Credit is one where a second bank, usually in the seller's country, adds its own guarantee to the LC issued by the buyer's bank. This confirmed LC provides the seller with additional security, particularly when they are uncertain about the issuing bank's creditworthiness. LC with bank confirmation reduces seller risk significantly in high-value or cross-border transactions.

Revolving Letter of Credit

A revolving Letter of Credit is designed for businesses that have ongoing and repeated transactions with the same trading partner. With a revolving LC, the credit amount is automatically reinstated after each use, so businesses engaged in repeated trade LC transactions do not need to apply for a new LC each time. This saves time and reduces lending costs for regular trade relationships.

Standby Letter of Credit

A Standby Letter of Credit, also referred to as an SBLC, serves as a backup payment guarantee rather than a primary payment instrument. The SBLC's meaning is that it is only activated if the buyer fails to fulfil their payment obligations. A standby LC gives the seller recourse in the event of buyer default, making it particularly useful in long-term contracts or service-based agreements where payment disputes may arise.

Sight Letter of Credit

A sight Letter of Credit requires the issuing bank to make payment immediately upon presentation of compliant documents. With a sight LC, there is no deferred payment period; once the bank verifies the documents, payment is released without delay. This immediate payment LC structure is preferred by sellers who want to minimise the time between shipment and receipt of funds.

Time or Usance Letter of Credit

A usance Letter of Credit, also known as a time Letter of Credit, allows the buyer to receive the goods and pay at a later agreed date. Under this deferred-payment LC structure, the bank accepts the documents and commits to releasing payment on the agreed-upon future date. This gives the buyer time to sell or process the goods before making payment, making it a useful tool for managing working capital in trade transactions.

Revocable vs Irrevocable Letter of Credit

A revocable Letter of Credit can be amended or cancelled by the issuing bank without prior notice to the seller, which creates significant risk for the beneficiary. An irrevocable LC, by contrast, cannot be changed or cancelled without the agreement of all parties involved, including the seller. When it comes to revocable vs irrevocable letters of credit, the latter are far more commonly used in practice because they provide a firm and binding payment commitment, making them the preferred choice for most trade transactions.

Transferable Letter of Credit

A transferable Letter of Credit allows the original beneficiary to transfer all or part of their payment rights to a third party, typically another supplier or manufacturer. This transferable LC structure is particularly useful for intermediaries or trading companies that source goods from sub-suppliers. LC for intermediaries of this kind enables the middleman to fulfil their obligations to the buyer without needing to use their own capital upfront.

When to Use a Letter of Credit

Knowing when to use Letter of Credit instruments helps businesses manage risk and improve trade confidence. Common LC use cases include:

• Dealing with a new supplier where there is no established trust or payment history.
• Cross-border trade involving different currencies, legal systems, or regulatory requirements.
• Large-value orders where either party needs assurance that obligations will be met.
• High-risk country transactions where political or economic instability creates payment uncertainty.
• Deferred payment structures, where the buyer requires time before settling the invoice.

Documents Required for a Letter of Credit

Missing or non-compliant LC documents are one of the most common causes of payment delays. The following Letter of Credit paperwork is typically required:

• The application form is completed by the buyer and submitted to the issuing bank.
• KYC documents, including identity and business registration proof for both parties.
• Commercial invoice detailing the goods, quantity, and agreed price.
• Bill of lading or airway bill as proof of shipment and transfer of ownership.
• An insurance certificate confirming that the goods are covered during transit.
• Certificate of origin confirming where the goods were manufactured or produced.
• Packing list describing the contents, weight, and packaging of the shipment.
• Other trade documents as specified in the LC, based on the nature of the transaction.

What Information Is Included in a Letter of Credit?

The contents of the Letter of Credit documents follow a structured format that clearly outlines all payment conditions. Understanding the information in LC helps both buyer and seller verify that the instrument is accurate before proceeding. A standard Letter of Credit format typically includes:

• Beneficiary details, including the seller's name, address, and official account information.
• LC amount specifying the maximum value the bank is committed to pay.
• Expiry date after which the LC is no longer valid, and documents cannot be submitted.
• Shipment terms covering the latest shipment date, port of loading, and port of destination.
• Bank details for both the issuing and advising/confirming banks.
• Required documents listing every document the seller must present to claim payment.
• Conditions for payment specifying any additional requirements that must be met before funds are released.

Example of a Letter of Credit

An example of a Letter of Credit (LC) involves a buyer and seller engaging in an international trade transaction. The buyer, wanting to ensure the timely delivery of goods, requests that their bank issue an LC in favour of the seller. The LC outlines specific conditions, such as shipping documents and quality certifications, that the seller must fulfil to receive payment.

Upon shipment, the seller presents the required documents to their bank, which, in turn, forwards them to the buyer's bank. If the documents comply with the LC terms, the buyer's bank makes the payment to the seller. This example showcases how an LC acts as a secure bridge, facilitating trust and ensuring a smooth transaction in the complex realm of global commerce.

Letter of Credit Key Terms Glossary

1. Applicant
2. Beneficiary
3. Issuing Bank
4. Negotiating Bank
5. Advising Bank
6. Confirming Bank
7. Intermediary

Understanding the following key terms is essential for all parties involved in Letter of Credit transactions to ensure smooth and secure international trade transactions.

Applicant: The party initiating the Letter of Credit (LC), often the buyer, requesting their bank's involvement to facilitate a secure transaction.

Beneficiary: The recipient of the LC, typically the seller, who will receive payment upon fulfilling the specified conditions outlined in the LC.

Issuing Bank: The bank that issues the LC on behalf of the buyer, assuming the responsibility of payment.

Negotiating Bank: The bank that reviews and negotiates the documents presented by the beneficiary, ensuring compliance with the LC terms.

Advising Bank: The bank that receives and verifies the LC before advising the beneficiary of its existence.

Confirming Bank: An optional third-party bank that adds its confirmation to the LC, providing an additional layer of assurance for the beneficiary.

Intermediary: A financial institution that facilitates communication between banks involved in the LC process, ensuring a smooth and secure transaction.

Advantages and Disadvantages of a Letter of Credit

Advantages of Letter of Credit (LC)	Disadvantages of Letter of Credit (LC)
Secure Payments: Ensures secure and timely payments.	Costly: Involves fees like issuance and advisory fees.
Trust Building: Fosters trust in international trade.	Complexity: Involves intricate documentation and steps.
Risk Mitigation: Reduces the risk of non-payment.	Time-consuming: Processing can be lengthy.
Flexibility: Various types cater to different needs.	Amendment Charges: Changes may incur additional fees.
Global Trade Facilitator: Supports cross-border trade.	Inflexible Terms: Strict adherence to LC terms is required.

How to Apply for a Letter of Credit

• Initiate Request: The buyer (applicant) initiates the request for an LC with their bank.
• Provide Transaction Details: Specify transaction details, terms, and conditions to the issuing bank.
• Creditworthiness Assessment: The issuing bank assesses the buyer's creditworthiness.
• LC Issuance: Upon approval, the issuing bank issues the LC.
• Transmission to Advising Bank: LC details are transmitted to the advising bank.
• Verification by Advising Bank: The advising bank verifies and informs the beneficiary about the LC.
• Confirmation (if applicable): A confirming bank may add its confirmation for additional assurance.
• Goods Shipment: The beneficiary ships the goods.
• Document Presentation: The beneficiary presents the required documents to the negotiating or confirming bank.
• Payment Processing: The negotiating or confirming bank processes payments based on compliant documents.
• Communication and Coordination: Effective communication among banks is crucial throughout the process.
• Precision and Adherence: Adherence to international trade norms and precise documentation are emphasised.

Why Should My Business Use a Letter of Credit?

Utilising a Letter of Credit (LC) offers several advantages for businesses engaged in international trade. Firstly, it provides a secure and standardised method for payment, mitigating the risk of non-payment and building trust between buyers and sellers. LCs also act as a financial tool, facilitating smoother transactions by specifying terms and conditions that must be met before payment is made.

For businesses dealing with unfamiliar partners or in regions with volatile financial environments, an LC adds an extra layer of assurance. It fosters a more predictable and structured approach to global transactions, reducing uncertainties and potential disputes. In essence, incorporating an LC into your business practices enhances financial security, streamlines international trade, and contributes to the overall efficiency and reliability of cross-border transactions.

Business Loan vs Letter of Credit: What’s the Difference?

A Letter of Credit is a trade finance instrument that ensures payment security between buyers and sellers, while a business loan provides direct funding to support day-to-day operations or expansion. An LC does not involve upfront fund disbursal, whereas a loan helps businesses manage working capital, procurement, or growth needs. The applicable business loan interest rates are an important factor to consider when evaluating borrowing costs.

In practice, both serve complementary roles. A business may use an LC to reduce payment risk in trade, while relying on financing to execute the order. Tools like a business loan eligibility calculator can help assess borrowing capacity and plan funding requirements effectively.

Conclusion

In conclusion, the Letter of Credit (LC) stands as a powerful instrument in the realm of international trade, offering businesses a secure and structured approach to transactions. Its role in fostering trust, mitigating risks, and providing a standardised payment method cannot be overstated. In the world of international trade, having the necessary financial support is paramount.

SMFG India Credit understands the challenges businesses face and offers tailored solutions, including business loans designed to meet the unique needs of enterprises engaged in global transactions. Whether you are expanding your operations, optimising your supply chain, or pursuing new opportunities, we can provide the financial backing you need.

You can use our business loan EMI calculator to estimate repayments and plan your cash flow more efficiently before applying online.