What is Letter of Credit (LC)? Examples and Uses

What is an LC (Letter of Credit)?

A Letter of Credit (LC) is a document issued by a bank that guarantees payment to a seller on behalf of a buyer, subject to specified conditions. This financial instrument ensures payment security and reduces risks in cross-border transactions. To receive payment, specific conditions must be met, typically including submission of required documents that the bank reviews before releasing funds. Most international documentary credits follow the Uniform Customs and Practice for Documentary Credits (UCP 600), and banks strictly examine documents against the LC terms; any non-conforming documents can be refused.

Examples of Letters of Credit

International Trade Example: A U.S. company wants to buy machinery from an Indian exporter. The U.S. company requests its bank to issue an LC to the Indian exporter. Once the exporter ships the machinery and presents the required documents to their bank, they receive payment from the issuing bank, ensuring trust and mitigating payment risk.

What documents are required for an LC?

Banks evaluate compliance based on documents, not physical goods. Accurate, complete paperwork is critical because payment decisions rest entirely on whether submitted documents meet LC terms.

• Commercial invoice: The seller’s bill showing price, parties, and payment terms; banks use it to verify the sale and payment amount.
• Bill of Lading (or Air Waybill): Proves shipment and, for a bill of lading, title to the goods; used to confirm carriage.
• Packing list: Details package contents, weights, and quantities; helps match shipped goods to the invoice.
• Certificate of Origin: Certifies where goods were produced; necessary for customs and preferential treatment.
• Insurance policy/cover note: Shows insurance coverage as required by the LC; protects against transit loss or damage.
• Draft/Bill of Exchange: A written demand for payment when the LC calls for a bill; banks negotiate or accept it per the terms.
• Inspection certificates (if required): Independent verification of quality or quantity when the LC demands inspection.
• Special documents: Specific permits or quality certificates required for certain commodities.

Domestic Transaction Example: A large retail chain uses an LC to purchase inventory from a local supplier. The LC guarantees that the supplier will receive payment as soon as they fulfil the delivery conditions outlined in the agreement.

Basics of a Letter of Credit Transaction

Applicant

The buyer who requests the LC from their bank. They initiate the process by applying for the LC and specifying the terms and conditions of the trade.

Beneficiary

The seller who receives payment through the LC. They must present all required documents correctly to receive payment.

Issuing Bank

The bank that issues the LC on behalf of the applicant. They verify the buyer’s creditworthiness and commit to making payment upon the conditions being met.

Negotiating Bank

The negotiating bank in an LC that examines documents presented by the beneficiary and facilitates payment. They ensure that all paperwork meets LC requirements exactly.

The process begins when the applicant requests an LC from their bank. The issuing bank then issues the LC and communicates it to the beneficiary, outlining the payment terms and conditions for the trade.

Importance of Letters of Credit

Secure Payments

They ensure sellers receive payments without requiring advance payments, thereby reducing risk for both parties to the letter of credit.

Facilitate Cross-Border Transactions

LCs simplify complex international transactions by providing a standardised payment mechanism across different countries.

Secure Business Funding

Letters of credit enhance cash flow management and can serve as collateral to secure financing. By guaranteeing payment, LCs help ensure liquidity while banks assess creditworthiness before extending funds.

Financial Assurance

LCs offer security when buyers cannot pay, acting as a guarantee backed by reliable banking institutions.

Advantages of Letters of Credit

LCs offer distinct benefits to both parties. For Buyers: They ensure payment assurance and help with negotiating favourable terms, though they may require collateral or tie up credit lines. For Sellers: LCs, particularly confirmed ones, deliver secure payment and improved receivables predictability, though strict documentary compliance remains essential. Trade-offs: Banks charge fees for these services, administrative procedures add complexity, and discrepancies in documentation can cause payment delays.

Foster Global Business Connections: Builds trust between trading partners by removing payment uncertainty and providing bank-backed guarantees.

Provide Flexibility: Customisable terms to suit various transaction needs, including payment timing, shipping requirements, and document presentation.

Parties to Documentary Credit

Commercial/Trade Parties: The applicant (buyer) and beneficiary (seller) drive the trade deal.

Banks: Issuing, advising, confirming, and nominated banks issue, authenticate, guarantee, and transmit documents to the beneficiary to ensure secure payment and proper documentation.

Related Entities: Shipping lines and insurers handle logistics and risk management.

Types of a Letter of Credit

Sight Credit

A Sight Credit allows instant payment upon presenting the correct documents, providing immediate access to funds for sellers. For example, if a business person needs quick access to cash after shipping goods, they can use this type of credit.

Acceptance Credit/Time Credit

Acceptance or Time Credit involves bills that are accepted upon presentation and paid on specified due dates. This type allows sellers to receive payments after a set period.

Revocable Letter of Credit

A Revocable Letter of Credit can be cancelled or modified by the issuing bank without beneficiary consent, which limits its reliability in ensuring secure transactions.

Irrevocable Letter of Credit

An Irrevocable Letter of Credit guarantees payment once certified by the exporter’s bank. This type provides security for international transactions and is often preferred by exporters due to its reliability.

Confirmed Letter of Credit

A Confirmed Letter of Credit involves both issuing and confirming banks. The confirming bank guarantees payment to the beneficiary, holding equal liability as the issuing bank, ensuring that payments will be honoured upon proper presentation.

Back-to-Back Letter of Credit

This type involves issuing a second LC based on the security provided by the first LC. It is commonly used to secure payments for suppliers in international trade transactions.

Transferable Letter of Credit

A Transferable Letter of Credit allows the primary beneficiary to partially or fully transfer credit to another beneficiary, typically a supplier. However, once transferred, the second beneficiary cannot further transfer it.

Restricted Letter of Credit

A Restricted Letter of Credit specifies a particular bank responsible for payment, limiting its scope compared to unrestricted LCs. This type is often used when specific banks are preferred due to their reliability.

Revolving Letter of Credit

A Revolving Letter of Credit allows reuse after payments or drawings are made. This flexibility is beneficial for businesses that require multiple shipments or ongoing transactions under a single credit arrangement.

Precautions to be Taken

Verify Bank Reliability: The issuing bank must be reliable and well-known to both parties of the letter of credit. This helps minimise risks and ensures the LC will be honoured when presented.

Local Bank Verification: It’s essential to advise through an Indian bank and confirm the authenticity of the LC. The local bank can verify the legitimacy of the foreign bank and ensure that all documents comply with local regulations.

Clarify Financial Terms: Make sure to clearly establish who covers all bank charges and confirm freight payment terms as specified in contract agreements. This prevents disputes and unexpected costs during the transaction process.

Import Export Code

The Import Export Code (IEC) is a mandatory registration in India for businesses engaging in cross-border trade and is often required when opening LCs for imports or exports. Apply through the government portal; processing typically takes 1–5 working days. Include your IEC and business registration documents when applying for an LC to streamline bank underwriting.

Frequently Asked Questions