A Letter of Credit (LC) is one of the most critical instruments in international and domestic trade, designed to reduce payment risk between buyers and sellers. In simple terms, a letter of credit is a bank’s written guarantee that the seller (exporter or supplier) will receive payment on time and for the correct amount, provided that the terms and conditions specified in the LC are strictly complied with. In global trade, where buyers and sellers often operate in different countries, legal systems, and currencies, the letter of credit acts as a bridge of trust backed by banks rather than individual counterparties.
In India, letters of credit are widely used by importers, exporters, manufacturers, traders, and large corporates to facilitate secure trade transactions. Banks issue and manage letters of credit under regulatory oversight of the Reserve Bank of India, and international rules framed by the International Chamber of Commerce (ICC), most notably the UCP 600 (Uniform Customs and Practice for Documentary Credits). Because of this structured legal and banking framework, LCs remain one of the safest and most accepted payment mechanisms in global commerce.
What Is a Letter of Credit?
A letter of credit is a documentary trade finance instrument issued by a bank (issuing bank) on behalf of a buyer (applicant), assuring the seller (beneficiary) that payment will be made once the seller presents documents that strictly comply with the LC terms. The bank’s obligation to pay is independent of the underlying sales contract, which makes the LC a powerful risk-mitigation tool.
In essence, the bank substitutes the buyer’s credit risk with its own. This is particularly valuable when the buyer and seller do not know each other well or are located in different jurisdictions.
Objectives of a Letter of Credit
The primary objective of a letter of credit is to ensure payment security in trade transactions. For the seller, it reduces the risk of non-payment. For the buyer, it ensures that payment is released only when goods are shipped as agreed and supported by proper documentation. LCs also help businesses manage cash flows, negotiate better trade terms, and build credibility in international markets.
Another important objective is risk allocation. By clearly defining documentation, shipment timelines, and compliance requirements, letters of credit reduce ambiguity and disputes in trade transactions.
Parties Involved in a Letter of Credit
A typical letter of credit transaction involves multiple parties:
- Applicant: The buyer/importer who requests the LC
- Issuing Bank: The buyer’s bank that issues the LC
- Beneficiary: The seller/exporter in whose favor the LC is issued
- Advising Bank: The seller’s bank that advises the LC
- Confirming Bank (optional): A bank that adds its own payment guarantee
- Negotiating Bank: The bank that checks documents and makes payment
Each party has defined roles, making the LC process structured and transparent.
How a Letter of Credit Works (Step-by-Step)
The LC process begins when the buyer and seller agree on payment through a letter of credit in their sales contract. The buyer applies to their bank for issuance of an LC in favor of the seller. The issuing bank sends the LC to the advising bank, which notifies the seller. The seller ships the goods and submits the required documents to the bank. If documents comply with LC terms, payment is released.
This process ensures that goods, documents, and payment are linked, reducing counterparty risk.
Types of Letter of Credit
Import Letter of Credit
Used in international trade where the importer’s bank guarantees payment to the exporter.
Export Letter of Credit
From the exporter’s perspective, this ensures payment from a foreign buyer.
Revocable Letter of Credit
Can be amended or cancelled without prior notice (rarely used today).
Irrevocable Letter of Credit
Cannot be changed without consent of all parties; most commonly used.
Confirmed Letter of Credit
Includes an additional guarantee from a confirming bank, reducing country or bank risk.
Standby Letter of Credit (SBLC)
Acts as a secondary payment guarantee, often used in domestic trade and contracts.
Revolving Letter of Credit
Used for recurring transactions over a period, avoiding repeated issuance.
Letter of Credit vs Other Payment Methods
Compared to advance payment, letters of credit offer security to buyers. Compared to open account trade, they significantly reduce seller risk. While documentary collections are cheaper, they do not provide the same level of payment assurance as an LC. Hence, LCs are preferred for high-value, cross-border, or high-risk transactions.
Key Documents Required Under a Letter of Credit
- Commercial Invoice
- Bill of Lading / Airway Bill
- Packing List
- Certificate of Origin
- Insurance Policy
- Inspection Certificate (if required)
Accuracy and strict compliance are critical. Even minor discrepancies can lead to delays or non-payment.
Applicable Charges in Letter of Credit
LC Issuance Charges
Usually charged as a percentage of the LC amount, often 0.10% to 0.50% per quarter, subject to minimum charges.
LC Advising Charges
Charged by the advising bank for authenticating and advising the LC.
LC Confirmation Charges
Applicable when a confirming bank adds its guarantee; depends on country risk and tenor.
LC Amendment Charges
Charged for any changes in LC terms after issuance.
Negotiation / Discounting Charges
Applicable if the exporter negotiates or discounts documents for early payment.
Discrepancy Charges
Levied when documents do not strictly comply with LC terms.
Actual charges vary by bank, transaction size, country risk, and customer profile.
Key Terms and Conditions in a Letter of Credit
LC Amount
The maximum amount payable under the LC.
Expiry Date
The last date for presentation of documents.
Shipment Date
The latest date by which goods must be shipped.
Incoterms
Defines responsibilities of buyer and seller (FOB, CIF, etc.).
Tenor
Sight LC (payment on presentation) or Usance LC (payment after a specified period).
Tolerance
Permissible variation in quantity or value, if allowed.
Risk Factors in Letter of Credit Transactions
While LCs reduce payment risk, they do not eliminate all risks. Document discrepancies, fraud, political risk, and bank risk are key considerations. Exporters should carefully review LC terms before shipment and ensure full compliance.
Letter of Credit in Indian Trade Finance Ecosystem
In India, letters of credit are extensively used in import of machinery, raw materials, petroleum products, and capital goods, as well as in export of textiles, pharmaceuticals, engineering goods, and commodities. Indian banks offer LC-backed working capital and export financing linked to these instruments.
Advantages of Using a Letter of Credit
- Reduces payment risk
- Enhances trade credibility
- Enables better negotiation power
- Facilitates bank financing
- Globally accepted and regulated
Limitations of Letter of Credit
- Higher cost compared to open account
- Complex documentation
- Risk of discrepancies
- Requires strong banking relationships
How to Apply for a Letter of Credit
Step-by-Step Process
- Finalize trade contract with LC terms
- Apply to bank with LC application form
- Submit margin and collateral (if required)
- Bank issues LC and sends to advising bank
- Seller ships goods and submits documents
How to Fill a Letter of Credit Application Form
Key Sections Explained
- Applicant details
- Beneficiary details
- LC amount and currency
- Shipment and expiry details
- Documents required
- Payment terms and tenor
Accuracy is critical, as LC terms mirror the application.
FAQs on Letter of Credit (Schema-Ready)
What is a letter of credit?
A letter of credit is a bank guarantee ensuring payment to a seller upon compliant document submission.
Is a letter of credit safe?
Yes, it is one of the safest trade finance instruments when properly structured.
Who pays LC charges?
Generally, the applicant (buyer) pays issuance charges, while other charges depend on trade terms.
What is the difference between LC and SBLC?
LC is primarily a payment mechanism; SBLC is a guarantee used as backup security.
Can an LC be cancelled?
An irrevocable LC cannot be cancelled without consent of all parties.
What happens if documents have discrepancies?
Payment may be delayed or refused unless discrepancies are accepted by the applicant.
Conclusion
A letter of credit remains the backbone of secure trade finance in both international and domestic commerce. By replacing counterparty risk with bank-backed assurance, it enables businesses to trade confidently across borders, currencies, and legal systems. While LCs involve costs, documentation discipline, and procedural rigor, their benefits far outweigh these limitations for high-value or high-risk transactions.
For importers, exporters, and growing businesses, understanding LC structures, charges, and terms is not just a banking necessity—it is a strategic advantage. When used correctly, a letter of credit does not merely facilitate trade; it builds trust, unlocks financing, and fuels global business growth.