What Is a Letter of Credit – Definition, Types and Process
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A letter of credit works by having the buyer's bank guarantee payment to the seller upon presentation of compliant documents. The buyer applies for an LC from their bank, which issues it in favour of the seller. The seller ships the goods and submits required documents (such as bill of lading, invoice, and certificates) to their bank. The bank examines the documents for compliance with LC terms. If compliant, the bank forwards them to the buyer's bank, which releases payment. This process ensures the seller receives payment and the buyer obtains proof of shipment before funds are transferred.
An example is Indian exporter shipping electronics worth ₹1 crore to a buyer in the United States. The US buyer's bank issues an LC guaranteeing payment to the Indian exporter. The exporter ships the goods, obtains a bill of lading from the shipping company, and prepares required documents including commercial invoice, packing list, and certificate of origin. The exporter's Indian bank reviews these documents and forwards them to the US bank. Upon verification, the US bank pays ₹1 crore to the Indian bank, which credits the exporter's account. The US buyer receives the documents to claim the goods upon arrival.
Payment occurs after the seller submits all required documents to their bank and the documents are found to be compliant with the LC terms. The timeline depends on the LC type. For a sight LC, payment occurs within a few days of document presentation. For a usance or deferred payment LC, payment occurs on a specified future date (such as 30, 60, or 90 days after shipment). The bank examines documents within a standard period (typically 5 banking days) to determine compliance. Once approved, funds are transferred from the issuing bank to the advising bank, which credits the seller's account.
A commercial letter of credit is used for a single transaction and becomes invalid once payment is made and documents are processed. It covers one shipment or delivery. A revolving letter of credit, however, allows multiple transactions over a specified period without issuing a new LC each time. The credit amount renews automatically after each draw, up to the stated limit and timeframe. For example, a revolving LC for ₹5 lakh per month over one year allows the seller to draw ₹5 lakh monthly, with the amount resetting after each transaction. Revolving LCs reduce administrative burden for ongoing business relationships.
A letter of credit (LC) and a bank guarantee (BG) serve different purposes. An LC is a payment mechanism used primarily in trade transactions where the bank pays the seller when specified documents are presented, regardless of whether the buyer defaults. It is intended to be used. A bank guarantee is a commitment by the bank to pay the beneficiary only if the applicant fails to fulfil contractual obligations. It serves as a backup and is not intended to be invoked under normal circumstances. LCs are documentary in nature and focus on document compliance, while BGs focus on performance or payment default.
The primary risks associated with letters of credit include document discrepancy risk, where errors in submitted documents lead to payment delays or rejection. Fraud risk exists when parties present falsified documents or misrepresent goods. Country risk involves political instability, currency restrictions, or banking system failures in the buyer's country that prevent payment. Legal risk arises from differing interpretations of LC terms across jurisdictions. Performance risk occurs when the LC does not address product quality issues, meaning payment occurs even if goods are defective. Buyers and sellers can mitigate these risks through careful LC drafting, document verification, and due diligence on all parties involved.
The validity of a letter of credit is specified in the LC document itself and varies based on the transaction requirements. Most LCs remain valid for 30 to 180 days from the issuance date, though this can be shorter or longer depending on the agreement between parties. The LC specifies an expiry date by which all documents must be presented to the bank. It also includes a latest shipment date, which must occur before the expiry date. If the seller cannot meet these deadlines, they can request an amendment to extend the validity period, subject to approval by the buyer and issuing bank. Once expired, the LC becomes void.
The best type of letter of credit depends on the specific transaction needs and risk profile. For standard international trade transactions, a commercial letter of credit offers balanced protection for both parties. For sellers concerned about the issuing bank's reliability, a confirmed letter of credit provides additional security through a second bank guarantee. For businesses engaged in regular shipments with the same partner, a revolving letter of credit reduces costs and administrative work. For high-risk transactions or situations where the buyer's creditworthiness is uncertain, a standby letter of credit offers backup payment assurance. Businesses should consult with trade finance experts to select the most appropriate LC type.
Disclaimer: This Article is for information purpose only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. The Bank makes no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Article. The information contained in this Article is sourced from empanelled external experts for the benefit of the customers and it does not constitute legal advice from the Bank. The Bank, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein
What Is a Letter of Credit?
A Letter of Credit (LC), is a formal document issued by a bank or financial institution on behalf of a buyer.
The bank guarantees that the seller will receive payment for goods or services, provided the seller meets the terms and conditions specified in the LC.
This payment mechanism protects both parties in a transaction by substituting the creditworthiness of a reputable bank for that of the buyer.
It is particularly important in international trade, where differing legal systems, currency fluctuations, and logistical challenges create additional risks.
Understanding Letters of Credit
Letters of credit operate through a structured process involving multiple parties and precise documentation. The typically begins when a buyer and seller agree on the terms of a transaction and decide to use an LC as the payment method.
This standardisation ensures that letters of credit function reliably across borders and legal jurisdictions.
How Much Do Letters of Credit Cost?
The cost of obtaining a letter of credit varies based on several factors, including the transaction amount, the buyer's creditworthiness, the type of LC, and the banks involved. Businesses must account for these expenses when planning international transactions.
The issuance fee is typically calculated as a percentage of the LC amount and depends on the buyer's creditworthiness. Buyers with strong credit profiles may pay lower fees, while those with limited credit history face higher charges. The bank may also require collateral or a security deposit before issuing the LC.
Confirmation fees apply when the seller requests additional security from a second bank in their country. This provides extra protection if the issuing bank fails to honour payment. Amendment fees are charged whenever changes are made to the LC after issuance, such as extending the validity period or modifying shipment terms.
Businesses should review these costs carefully and factor them into pricing negotiations. In some transactions, the buyer and seller may agree to share LC costs, while in others, one party bears the full expense.
Different Types of Letters of Credit
Letters of credit come in various forms, each designed to address specific transaction needs and risk profiles. Understanding these types helps businesses select the most appropriate instrument for their trade requirements.
Commercial Letter of Credit
A commercial letter of credit is the standard form used in most international trade transactions. It facilitates direct payment from the buyer's bank to the seller upon presentation of compliant documents. This type is widely used for the import and export of goods where the seller requires payment assurance before shipping products.
Standby Letter of Credit
A standby letter of credit functions as a backup payment mechanism rather than a primary payment method. It is invoked only if the buyer fails to fulfil their payment obligations under the contract. This type serves as insurance for the seller, providing a guarantee that payment will be made even if the buyer defaults.
Revolving Letter of Credit
A revolving letter of credit allows multiple transactions within a specified period without requiring a new LC for each shipment. This type is beneficial for businesses engaged in regular trade with the same partner, such as monthly shipments of goods over a year-long contract.
Traveler's Letter of Credit
A traveler's letter of credit was historically used by individuals travelling abroad to access funds at foreign banks. The issuing bank guaranteed payment to foreign banks that honoured drafts presented by the traveler. This type has largely been replaced by traveler's cheques, credit cards, and international ATM networks in modern banking.
Confirmed Letter of Credit
A confirmed letter of credit involves a second bank (the confirming bank) adding its guarantee to the LC issued by the buyer's bank. This provides the seller with dual assurance of payment—both from the issuing bank and the confirming bank. If the issuing bank fails to honour payment, the confirming bank steps in to fulfil the obligation.
Example of a Letter of Credit in Action
To understand how letters of credit work in practice, consider the following scenario involving an international trade transaction.
The Scenario:
An Indian textile manufacturer (the seller) receives an order from a retail company in Germany (the buyer) for ₹50 lakh worth of cotton fabric. The two companies have not conducted business together before, and the seller is concerned about payment risk.
The buyer agrees to arrange a commercial letter of credit to secure the transaction.
Step-by-Step Process:
Step 1: Agreement and LC Application The buyer and seller finalise the sales contract, specifying product details, quantity, price, shipment terms, and delivery timeline. The contract stipulates that payment will be made through a letter of credit. The German buyer approaches their bank and applies for an LC in favour of the Indian seller.
Step 2: Creditworthiness Assessment The German bank evaluates the buyer's financial standing, reviewing credit history, cash flow, and collateral. After approval, the bank issues the LC for ₹50 lakh with specific terms: shipment within 60 days, presentation of a bill of lading, commercial invoice, packing list, and certificate of origin within 21 days of shipment.
Step 3: LC Transmission The German issuing bank sends the LC to the seller's bank in India through the SWIFT network. The Indian bank (advising bank) reviews the LC and notifies the textile manufacturer. The seller examines the terms to confirm they match the sales agreement.
Step 4: Production and Shipment Satisfied with the LC terms, the seller proceeds with fabric production. Once completed, the seller arranges shipment via a freight forwarder. The goods are loaded onto a vessel bound for Germany, and the seller receives a bill of lading from the shipping company as proof of shipment.
Step 5: Document Preparation The seller prepares the required documents:
Step 6: Document Submission The seller submits these documents to their Indian bank within the specified timeframe. The bank examines the documents against the LC terms, checking for accuracy, completeness, and compliance.
Step 7: Payment Processing Finding the documents compliant, the Indian bank forwards them to the German issuing bank. The German bank verifies the documents and, upon confirmation, releases payment of ₹50 lakh to the Indian bank. The Indian bank credits the seller's account, completing the transaction.
Step 8: Document Delivery to Buyer The German issuing bank delivers the shipping documents to the buyer, who uses the bill of lading to claim the goods from the shipping company upon arrival in Germany. The buyer's account is debited for ₹50 lakh plus any agreed-upon fees.
Outcome: The seller received guaranteed payment before the buyer took possession of the goods, while the buyer obtained assurance that payment would only be made upon proof of shipment. The letter of credit successfully mitigated payment risk for both parties, enabling a smooth international transaction despite the absence of a prior business relationship.
How to Apply for a Letter of Credit
Preparation of Letters of Credit demands adept handling by professionals due to the intricate nature of the required documentation, as inaccuracies can result in payment delays and additional fees. Given the diversity across industries and types of Letters of Credit, each case necessitates a tailored approach.
Consider the scenario of import-export transactions:
Pros and Cons of Letters of Credit
Letters of credit offer significant advantages for international trade but also come with limitations that businesses must consider.
Offers reassurance to sellers by ensuring payment even if buyers default.
Imposes fees on buyers, potentially limiting options for certain sellers.
Establishes trust and reliability, particularly in new or international trade relationships.
Does not address all transactional aspects, such as delivery speed or product quality.
Provides clear guidelines for payment timelines.
Fails to accommodate unforeseen circumstances like fluctuating exchange rates, political instability, or supply chain disruptions.
Facilitates efficient fund transfers through intermediaries, which is particularly beneficial in complex international transactions.
Involves a time-consuming process for both parties.
Customisable to suit specific transaction requirements.
Conclusion
Letters of credit serve as a fundamental tool in international trade, providing payment security for sellers and delivery assurance for buyers.
By involving banks as intermediaries, LCs reduce the risks associated with cross-border transactions, enabling businesses to expand into new markets with confidence.
Businesses engaged in international trade should evaluate whether letters of credit align with their transaction requirements, risk tolerance, and partner relationships.
Consulting with trade finance specialists and banks can help determine the most appropriate payment mechanism for specific situations.
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