Letters of Credit, Explained: How Banks Reduce Payment Risk in Trade

When a small manufacturer in Ohio agrees to ship machine parts to a buyer in Vietnam, two problems arise immediately. The buyer worries about paying for goods that might never arrive, and the seller worries about shipping goods that might never be paid for. A letter of credit, or LC, is one of the oldest financial tools designed to solve exactly this problem by inserting a bank's creditworthiness between two parties who may not know or trust each other.

What a Letter of Credit Actually Does

An LC is a document issued by a bank, on behalf of a buyer (the applicant), promising to pay a seller (the beneficiary) a specified amount, provided the seller presents documents that comply exactly with the terms of the credit. Those documents typically include a bill of lading proving the goods were shipped, a commercial invoice, a packing list, and sometimes an inspection certificate or certificate of origin.

Crucially, the bank is paying against documents, not against the physical goods themselves. This is a frequently misunderstood point: a bank examining an LC claim is not verifying that the machine parts arrived in good condition, only that the paperwork presented matches what the credit requires. This document-based structure is formalized globally under the Uniform Customs and Practice for Documentary Credits (UCP 600), a rulebook published by the International Chamber of Commerce that most banks worldwide adopt by reference in their LC terms.

The Main Types of Letters of Credit

• Irrevocable LC: The issuing bank cannot cancel or amend the credit without the agreement of all parties, which is the standard form used in most trade transactions today.
• Confirmed LC: A second bank, usually in the seller's home country, adds its own payment guarantee on top of the issuing bank's promise, useful when the seller doesn't trust the buyer's bank or the buyer's country's banking system.
• Standby LC: Functions more like a guarantee than a payment mechanism; the bank pays only if the buyer fails to perform, similar in spirit to a performance bond.
• Revolving LC: Automatically renews for a set amount over multiple shipments, reducing the administrative burden for buyers and sellers in ongoing trade relationships.
• Red clause LC: Allows the seller to receive a partial advance payment before shipment, often used to help finance production of goods.

How the Process Typically Works

The sequence generally follows a set pattern. First, the buyer and seller agree on LC terms as part of their sales contract. The buyer then applies to its bank, known as the issuing bank, which evaluates the buyer's creditworthiness and issues the LC, often requiring collateral or a credit line. The issuing bank sends the LC to the seller's bank, known as the advising bank, which notifies the seller. The seller ships the goods and presents the required documents to the advising bank, which forwards them to the issuing bank for review. If the documents comply exactly with the LC's terms, the issuing bank pays, and the buyer reimburses its bank, often by drawing on a pre-arranged credit facility.

Costs and Who Bears Them

Banks charge fees for issuing, advising, confirming, and negotiating LCs, and these costs vary by the bank, the buyer's credit profile, the countries involved, and whether confirmation from a second bank is required. Fee structures commonly include an issuance fee charged as a percentage of the credit value, plus separate confirmation and document-handling charges. Buyers and sellers typically negotiate in advance which party bears which fees, and this allocation is spelled out in the sales contract alongside the LC terms.

Why This Matters Beyond Importers and Exporters

Letters of credit are not just a back-office detail for trading companies; they appear in the broader financial system in several ways relevant to investors and finance-curious readers. Banks report trade finance exposures, including LCs, as off-balance-sheet commitments in their regulatory filings and financial statement footnotes, since an issued LC represents a contingent liability the bank may have to fund. Companies that rely heavily on international suppliers or customers, such as commodity traders, agribusiness firms, and manufacturers with long overseas supply chains, often disclose their use of LCs and trade finance facilities in the liquidity or commitments sections of their SEC filings. A sudden reduction in available LC capacity, whether due to a bank tightening credit or geopolitical sanctions limiting correspondent banking relationships, can signal emerging stress in a company's ability to source goods or get paid for exports.

The Bottom Line

A letter of credit works because it substitutes the creditworthiness of a bank for the uncertain trust between a buyer and seller who may be separated by oceans, legal systems, and currencies. For businesses engaged in cross-border trade, understanding the mechanics, the strict documentary requirements, and the cost tradeoffs is essential to using LCs effectively. For investors, recognizing how and why a company relies on trade finance instruments like LCs can offer a window into its counterparty risk and operational resilience in global markets.