Letters of Credit Explainer
A letter of credit is a bank’s commitment to pay a beneficiary when specified documents comply with stated terms. In international trade, an importer asks its bank to issue the letter for an exporter. The arrangement substitutes the bank’s payment promise for reliance solely on the buyer, helping parties that lack a long operating history together.
After shipment, the exporter presents required documents, which may include invoices, transport records, insurance certificates, or inspection evidence. Banks examine documents rather than the physical goods. A discrepancy can delay payment or require the buyer to waive the defect, even when the underlying shipment is commercially acceptable.
A confirmed letter adds a second bank’s payment undertaking, reducing exposure to the issuing bank or country. Standby letters serve more like backstop guarantees, while commercial letters are intended as the payment mechanism. Each form has different fees, expiry dates, drawing conditions, and operational demands.
Letters of credit reduce some counterparty risks but add documentary, bank, fraud, sanctions, timing, and country risks. Vague conditions and inconsistent records can defeat their purpose. Parties should align the sales contract and credit terms, use trained document specialists, confirm bank acceptability, and leave time to correct discrepancies before expiry.
Payment depends on compliant records, not direct inspection of goods.
Exact wording and deadlines matter.
A confirming bank can assume payment responsibility alongside the issuer.
That protection carries additional cost.
Discrepancies, sanctions, fraud, and country conditions can delay payment.
Coordinate the contract and document list carefully.
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