Letter of Credit
A letter of credit is a bank’s conditional undertaking to pay when the seller presents documents that comply with its stated terms. Banks examine documents rather than confirming the physical quality or performance of the goods.
Also called: LC · L/C · documentary credit
A letter of credit moves the payment risk in a trade from the buyer to a bank. The buyer's bank, the issuing bank, undertakes to pay the seller once the seller presents documents that match the credit's terms, typically a commercial invoice, a bill of lading, a packing list and sometimes an inspection certificate. Most commercial letters of credit are issued subject to the ICC's Uniform Customs and Practice for Documentary Credits, UCP 600, which sets out how banks examine documents and what counts as a complying presentation.
For a Chinese exporter, a credit offers assurance that payment does not depend on the importer's willingness to pay after shipment. For the importer, it offers assurance that money is released only against evidence of shipment. A seller that doubts the issuing bank can ask another bank, often one in its own market, to confirm the credit, adding that bank's own undertaking to pay. Confirmation, issuance, amendment and discrepancy fees all add to the cost, which is why letters of credit are more common on larger or first-time transactions.
The protection is documentary, not physical. Banks check whether the documents comply on their face; they do not inspect the goods, test the machinery or verify that the cargo matches the invoice. A small inconsistency, such as a misspelled consignee, a late shipment date or a description that differs between documents, can make a presentation discrepant and delay or defeat payment. Careful drafting of the credit's conditions, and an independent inspection requirement where quality matters, are what make the instrument useful in practice.
In practice
A letter of credit guarantees payment against documents, not satisfaction with the goods. If the documents comply, the bank pays even if the cargo later turns out to be defective, so quality protection has to come from inspection terms and the contract.
Example
Hypothetically, a US importer opens a US$400,000 letter of credit for a machinery order from a factory in Jiangsu. The credit requires a clean on-board bill of lading dated no later than 30 June and a third-party inspection certificate. The factory ships on 28 June and presents compliant documents, so the confirming bank pays. Had the certificate been missing, the presentation would have been discrepant and payment would have waited for the importer to waive the discrepancy.
Commonly confused with
| Term | How it differs |
|---|---|
| Documentary collection | In a collection, banks only exchange documents for payment or acceptance and make no promise to pay. Under a letter of credit, the issuing bank itself undertakes to pay against a complying presentation. |
See also
- Documentary CollectionA documentary collection is a trade-payment method in which banks handle shipping or commercial documents in exchange for payment or acceptance. The banks facilitate the process but do not provide the same payment guarantee as an issuing bank under a letter of credit.
- Commercial InvoiceA commercial invoice is the seller’s formal statement of the goods or services supplied and the amount owed by the buyer. Banks, customs authorities and payment providers may use it to verify the payment amount, parties, currency and commercial purpose.
- Bill of LadingA bill of lading is a transport document issued in connection with the carriage of goods by sea. Depending on its form, it can evidence receipt of the goods, contain the carriage terms and function as a document controlling delivery.
- Cash in AdvanceCash in advance requires the buyer to pay before the seller ships or releases the goods. It protects the supplier against nonpayment but gives the buyer less protection if the goods are late, defective or never delivered.
- Open-Account TradeOpen-account trade allows the buyer to receive goods or services before payment becomes due. It supports the buyer’s working capital but leaves the supplier exposed to the buyer’s credit and payment risk.