A comprehensive guide to the letter of credit: Definition, types, and benefits

What is a letter of credit?

A Letter of Credit, often abbreviated as LC, is a formal written undertaking by a bank on behalf of a buyer (the applicant) to pay a seller (the beneficiary) a specified sum of money, provided the seller presents a set of pre-defined documents that comply strictly with the terms and conditions outlined in the LC.

In essence, it's a conditional payment guarantee issued by a financial institution. A letter of credit is also known as a documentary credit and is widely used in international trade ².

The core function of an LC is to substitute the bank’s creditworthiness for that of the buyer. This is paramount in international trade, where a seller may have limited information about a buyer’s financial stability or willingness to pay.

By introducing a bank into the transaction, the issuing bank assumes the credit risk of the buyer. Commercial letters of credit are the most common form used in business transactions. This provides an unparalleled level of payment security for the seller, assuring them that they will be paid as long as they fulfil their end of the bargain—namely, shipping the goods and presenting the correct paperwork ⁷.

Letters of Credit are crucial tools for mitigating the inherent risks of cross-border transactions. They address legal risks by being governed by a standard set of rules known as the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce (ICC).

The letter of credit operates under a separate credit agreement between the bank and the applicant, which is distinct from the underlying sales contract. This creates a clear, binding agreement and a framework for dispute resolution. Furthermore, they significantly reduce payment risks, making them an indispensable instrument for businesses operating on a global scale by helping both buyers and sellers minimise payment risk in international transactions ¹.

How do letters of credit work?

The operational flow of a Letter of Credit involves several key parties and follows a structured, systematic process. While the details can vary, the fundamental steps remain consistent, ensuring transparency and security throughout the transaction ².

The Key Parties Involved:

• Applicant (Buyer/Importer): The party who requests the Letter of Credit from their bank.
• Issuing Bank (also known as the buyer's bank): The applicant’s bank that issues the Letter of Credit, guarantees the payment, and plays a central role in the process.
• Beneficiary (Seller/Exporter): The party who will receive the payment under the Letter of Credit.
• Advising Bank (which may also be referred to as the exporter's bank or seller's bank): A bank in the beneficiary’s country that authenticates the LC and forwards it to the beneficiary. It does not typically guarantee payment unless it also acts as a confirming bank.
• Confirming Bank (Optional): A bank that adds its own guarantee of payment to the LC, in addition to that of the issuing bank ^1,7.

The Step-by-Step Process:

1. Sales Agreement: The buyer and seller agree on the terms of a sale, including price, quantity, shipping details, and payment method. They stipulate in the contract that payment will be made via a Letter of Credit ².
2. LC Application: The buyer (applicant) approaches their bank (the issuing bank or buyer's bank) and formally applies for a Letter of Credit. Banks play a central role in assessing credit risk, issuing the LC, and ensuring compliance with international regulations such as UCP 600. The application includes all the terms agreed upon in the sales contract, such as the required documents, shipment deadlines, and expiry date of the credit ^1,7.
3. LC Issuance: After assessing the buyer’s creditworthiness and securing collateral if necessary, the issuing bank grants approval of the application and issues the LC. It then transmits the LC to a correspondent bank (the advising bank, which may be the exporter's bank or seller's bank) in the seller’s country, typically through the secure SWIFT (Society for Worldwide Interbank Financial Telecommunication) network ⁴.
4. Advising the LC: The advising bank verifies the authenticity of the LC and forwards it to the seller (beneficiary). The seller reviews the LC to ensure it matches the terms of the sales contract. If there are any discrepancies, they must request an amendment from the buyer ¹.
5. Shipment of Goods: Confident in the bank’s payment guarantee, the seller proceeds to ship the goods as per the LC’s requirements. Payment is triggered once the exporter ships the goods and provides evidence of goods shipped ¹⁰.
6. Document Presentation: The seller gathers all the required documentation specified by the LC. These commonly include a commercial invoice, a transport document (like a Bill of Lading) as proof of goods shipped, an insurance policy, a certificate of origin, and a packing list. The seller presents these requested documents to their bank (which could be the advising, nominated, exporter's bank, or seller's bank) ¹⁰.
7. Document Examination and Payment: The bank examines the required documentation meticulously. If the documents are in strict compliance with the LC terms (a condition known as a “complying presentation”), the bank grants approval and is responsible for paying the beneficiary the specified amount upon verification that the requested documents match the LC terms ⁵.
   
   1. If it’s a sight LC, the bank pays the seller immediately.
   2. If it’s a usance LC, the bank accepts a draft to pay the seller on a future date.
8. Interbank Settlement: The seller’s bank forwards the documents to the issuing bank for reimbursement. The issuing bank performs its own examination. If the documents comply, it honours the payment and reimburses the seller’s bank ¹.
9. Final Settlement: The issuing bank debits the buyer’s account and releases the documents to the buyer. The buyer uses these documents (particularly the Bill of Lading) to claim the goods from the shipping company upon their arrival ¹⁰.

Types of letters of credit

Letters of Credit are not a one-size-fits-all solution. Various types have evolved to meet the diverse needs of global trade, each offering different levels of security, flexibility, and purpose.

• Commercial Letter of Credit: This is the most common type, used as a primary payment method for a specific shipment of goods. Exporters often use an export LC to secure payment and mitigate risk in international transactions ^3,7.
• Standby Letter of Credit (SBLC): Unlike a commercial LC, an SBLC is a secondary payment method. It acts as a performance guarantee. The beneficiary can only draw on an SBLC if the applicant fails to fulfil their contractual obligations (e.g., defaults on payment). It functions more like a bank guarantee ¹¹.
• Revolving Letter of Credit: Ideal for long-term business relationships with regular shipments. This type allows for multiple draws up to a certain amount within a specific period. The credit line is automatically replenished after each draw, eliminating the need to apply for a new LC for every transaction ³.
• Confirmed Letter of Credit: This type provides maximum security to the seller. In addition to the issuing bank’s guarantee, a second bank (the confirming bank, usually in the seller’s country) adds its own confirmation, or guarantee, of payment. This is used when the seller is concerned about the credit risk of the issuing bank or the political/economic stability of the buyer’s country ¹².
• Unconfirmed Letter of Credit: An LC that is only guaranteed by the issuing bank. The advising bank simply authenticates the LC but does not add its own payment guarantee ³.
• Transferable Letter of Credit: This allows the original beneficiary (e.g., a middleman or trading agent) to transfer their rights and part of the credit to another party (the actual supplier). This is useful in supply chains where the intermediary does not produce the goods themselves ³.
• Back-to-Back Letter of Credit: A more complex arrangement where a middleman uses an incoming LC from the end-buyer as collateral to open a second, separate LC for their supplier ¹³.
• Sight Letter of Credit: Stipulates that payment is to be made immediately (typically within 5-10 banking days) upon the presentation of compliant documents.
• Usance Letter of Credit (Deferred Payment/Acceptance): Allows for delayed payment. The payment is made at a specified future date after the documents have been presented and accepted (e.g., 60 days after the Bill of Lading date). This provides a form of short-term financing for the buyer ⁵.
• Red Clause Letter of Credit: A special type that includes a clause (traditionally typed in red ink) authorising the advising bank to make an advance payment to the seller before the goods are shipped. This serves as pre-shipment financing for the seller.

Export LCs and export LCs (plural) are financial instruments that help suppliers minimise export payment risk and access financing. These instruments are often provided as part of a broader credit facility by banks, supporting exporters in securing transactions and improving payment security in international trade ^6,14.

Benefits and costs of a letter of credit

While highly effective, LCs come with both significant advantages and associated costs that businesses must weigh.

Benefits

Letters of credit provide security for both buyers and sellers, ensuring payment as long as the terms are met. The terms and effectiveness of a letter of credit can also be adjusted to suit the unique circumstances of each international transaction ^2.7.

Costs

The use of a letter of credit involves various fees, including issuance, advising, and confirmation charges. The credit cost of a letter of credit includes these bank fees and is influenced by the type of LC and the bank's assessment of risk. These costs can add up, making LCs more expensive than other payment methods ^8,9,15.

Benefits 

• High Payment Security: For sellers, the primary benefit is the assurance of payment from a bank, virtually eliminating the buyer's credit risk ^1,2.
• Reduced Risk for Buyers: Buyers are assured that the bank will only release payment after the seller has provided proof of shipment and other documents as stipulated in the LC ².
• Access to Financing: Sellers can often use an LC as collateral to obtain pre-shipment or post-shipment financing from their bank ⁷.
• Facilitates New Relationships: LCs enable trade between parties who don't know each other, building trust and opening up new market opportunities ².
• Customisable and Flexible: The terms of an LC can be tailored to meet the specific requirements of any transaction ^2,7.

Costs

Bank Fees: Both buyers and sellers incur fees. These can include ^1,2,15,16:

• Issuance Fee: Charged to the buyer, typically 0.5% to 2% of the LC value.
• Confirmation Fee: Charged for confirmed LCs, usually paid by the seller.
• Advising Fee: A flat fee for advising the credit.
• Discrepancy Fee: A significant fee charged if the presented documents contain errors.
• Amendment Fee: Charged for any changes made to the LC after issuance.
• Complexity: The process is document-intensive and requires meticulous attention to detail. Errors in documentation are common and can lead to payment delays or refusal.
• Time-Consuming: The back-and-forth process of application, issuance, and document verification can be slower than open account or direct payment methods.

How to apply for a letter of credit in Hong Kong

Hong Kong, as a major global trade hub, has a sophisticated banking system well-equipped to handle Letters of Credit. The application process is standardised across major financial institutions 7,8.

1. Establish a Banking Relationship: The applicant (importer) must have a business account with a bank in Hong Kong that offers trade finance services, such as HSBC, Standard Chartered, or Bank of China (Hong Kong) ^7,8,9.
2. Secure a Trade Finance Facility: Before applying for an LC, a business typically needs to secure a trade finance or LC facility with the bank. This involves a credit assessment where the bank evaluates the company’s financial health, trading history, and operational stability. Collateral, such as a cash deposit or property, may be required. The bank will also require a credit agreement to be in place before issuing the LC, outlining the legal and contractual framework for the facility ^7,8.
3. Complete the Application Form: The applicant fills out the bank’s official LC application form. This can usually be done through the bank’s online trade portal or by submitting a physical form ^9,11.
4. Provide Detailed Information: The application must contain precise details derived from the sales contract or proforma invoice ¹⁰:
   
   1. Beneficiary Details: Full name, address, and bank information of the seller.
   2. Credit Details: The LC amount and currency.
   3. Dates: The latest date for shipment and the expiry date of the LC.
   4. Goods Description: A clear and accurate description of the goods.
   5. Shipment Terms: Incoterms (e.g., FOB, CIF), ports of loading and destination.
   6. Required Documents: A specific list of documents the seller must present (e.g., Commercial Invoice, full set of clean on-board Bill of Lading, Insurance Policy, Certificate of Origin). The applicant must clearly list all requested documents and terms to ensure compliance with the LC requirements.
5. Submit and Await Issuance: The completed application is submitted to the bank. The bank’s trade finance team reviews it for clarity and completeness. The LC will only be issued after the bank grants approval, ensuring all conditions and requirements are met. Once approved, the bank issues the LC and transmits it to the beneficiary’s bank via SWIFT ⁴.

Letter of credit common mistakes

The strict compliance nature of LCs means that even minor errors can lead to major problems. Awareness of these common mistakes is the first step to avoiding them ¹⁶.

• Documentary Discrepancies: This is the number one reason for payment delays. Errors can include typos in names or addresses, inconsistent descriptions of goods across different documents, or mathematical errors in invoices.
• Expired Credit: The seller fails to present the documents to the bank before the LC’s expiry date ¹.
• Late Shipment: The goods are shipped after the “latest shipment date” specified in the LC.
• Unworkable Terms: The buyer includes terms in the LC that are impossible for the seller to fulfil, such as requiring a certificate from an organisation that does not issue them. In such a case, the LC may become unworkable, and the transaction cannot proceed unless the terms are amended.
• Failing to Amend: The buyer and seller agree to change an aspect of the deal (e.g., extend the shipment date) but fail to formally amend the LC to reflect this change. The original LC terms will still apply.
• Incomplete Presentation: The seller forgets to include one of the documents required by the LC. If the seller is unable to provide all required documents, payment may be delayed or refused ¹⁶.

Letter of credit best practices

To harness the full potential of LCs and ensure a smooth transaction, both buyers and sellers should adhere to several best practices. It is also crucial to understand the obligations of the other party in the letter of credit transaction, as clear knowledge of each party's responsibilities helps ensure compliance and smooth processing ¹.

For the seller (Beneficiary)

• Review the Draft LC: Before it is formally issued, ask the buyer for a draft. Scrutinise every detail to ensure you can comply with all terms and conditions.
• Check for Clarity: Ensure there are no ambiguous terms. What seems clear to the buyer might be interpreted differently by a bank document checker.
• Prepare Documents Carefully: Treat document preparation with the utmost seriousness. Use a checklist and have a second person review everything before submission.
• Mind the Deadlines: Be acutely aware of the latest shipment date, the document presentation period, and the LC expiry date.

For the buyer (Applicant)

• Be Precise and Practical: When applying for the LC, provide clear, concise, and accurate information. Do not request unnecessary documents that complicate the process for the seller.
• Set Realistic Timelines: Allow the seller ample time to ship the goods and prepare the necessary documents.
• Communicate Openly: Maintain clear communication with the seller throughout the process, especially if amendments are needed.

Streamline your global payment process with Aspire

While Letters of Credit remain the gold standard for securing high-value international transactions, their procedural complexity and cost can be burdensome for modern, fast-moving businesses. The traditional, paper-heavy process can feel slow in an increasingly digital world.

For businesses looking to complement their trade finance toolkit, modern financial platforms like Aspire offer a more streamlined approach to managing global payments. Aspire provides multi-currency accounts that allow you to hold, send, and receive funds in multiple currencies, significantly reducing conversion costs and FX risks. With faster international transfers and integrated expense management tools, you can handle payments to suppliers, contractors, and partners with greater speed and efficiency.

By leveraging a platform like Aspire for your operational payments and recurring international transactions, you can reserve Letters of Credit for the large, high-risk shipments where their unparalleled security is most needed. This hybrid approach allows your business to stay agile and cost-effective while retaining the robust protection of traditional trade finance when it matters most.