What is a letter of credit?

Letters of credit are used in international trade, often where buyer and seller do not know each other well. The seller relies on the bank's promise instead of only the buyer's.

Why a letter of credit matters

An exporter shipping goods to a new buyer overseas takes two risks. The buyer may not pay, and it is hard to chase an unpaid invoice across borders. The buyer takes a risk too: paying before the goods are on their way. A letter of credit splits the difference. The bank pays against documents that show the goods were shipped as agreed.

This is a general explanation, not legal, tax or financial advice. Bank fees and rules vary, so talk to your bank before you rely on one.

The parties

• Applicant: the buyer, who asks their bank to open the credit.
• Issuing bank: the buyer's bank, which issues the credit.
• Beneficiary: the seller, who is paid.
• Advising bank: a bank in the seller's country, often the seller's own bank, which passes the credit on to the seller after checking that it appears genuine.
• Confirming bank: an optional bank, often the advising bank, that adds its own promise to pay. It is used when the seller wants more security than the issuing bank alone.

How it works

1. Buyer and seller agree a sale and state that payment will be by letter of credit.
2. The buyer asks their bank to issue the credit, naming the seller and listing the documents required.
3. The issuing bank sends the credit to the seller, usually through the advising bank.
4. The seller ships the goods and collects the documents: for example the commercial invoice, the transport document and a packing list. A certificate of analysis may also be required.
5. The seller presents the documents, usually through their own bank, before the credit's deadline.
6. The bank checks them against the credit. If they comply, the seller is paid at once or on the agreed later date, depending on the credit's terms.
7. The documents go on to the issuing bank, which releases them to the buyer. The buyer usually needs them to collect the goods.

Banks deal in documents, not goods. If the documents do not comply with the credit's terms, the bank can refuse them, even if the goods are perfect. So a wrong name, a missing document or a late presentation can hold up payment.

The rules behind it

Most letters of credit state that they are subject to the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits, the 2007 revision known as UCP 600. It sets out how banks examine documents and handle credits. The rules apply because the credit says so, so check that yours does.

An example from product sales

Say a specialty chemicals maker agrees to ship 4 containers to a buyer in a new market. The buyer's bank issues a letter of credit that needs an invoice, a transport document, a packing list and a certificate of analysis. The rep checks the credit as soon as it arrives, finds the product description differs slightly from the quote, and asks the buyer to amend it before shipping.

Related terms

• Incoterms: the delivery terms that shape which documents appear.
• Pro forma invoice: often used to open a credit.
• Sales quote: the credit should match it.
• Purchase order: the buyer's order that the credit supports.

How PromptLab handles it

The credit itself is handled by the banks. PromptLab holds the commercial record the credit depends on: the quote, the customer's price list, the sales order, and the account's email and files. Because the credit must match those terms, having them in one place makes checking easier.

Frequently asked questions

What is a letter of credit in simple terms?

It is a bank's promise to pay the seller, as long as the seller hands over the documents the credit asks for, on time and as written.

Who pays for a letter of credit?

Fees depend on the agreement and the banks. Buyer and seller should agree who pays which charges when they settle the terms of sale.

What is a confirmed letter of credit?

It is one where a second bank, usually in the seller's country, adds its own promise to pay. That gives the seller extra security.

What does UCP 600 mean?

It is the set of rules published by the International Chamber of Commerce that most letters of credit follow. It describes how banks examine documents and handle credits.

Why would a bank refuse the documents?

Usually because they do not match the credit exactly, for example a different description, a missing document or a late presentation. This is called a discrepancy.