Letter of Credit

A letter of credit (LC), also called a documentary credit, is a written undertaking by a bank, issued at the request of a buyer, to pay a seller a stated amount provided the seller presents specified documents that comply with the credit's terms within a set period. The bank deals only in documents: it checks that the invoice, transport documents and certificates presented match the credit's requirements on their face, and it does not inspect the goods or judge whether the underlying contract was performed. Letters of credit are a central instrument of trade finance, used when a seller and buyer do not know or trust each other well enough to trade on open terms.

By replacing the buyer's promise to pay with a bank's, the LC protects the seller against non-payment, while the buyer gains assurance that payment will be made only against evidence of shipment.

• Applicant. The buyer, who asks its bank to issue the credit.
• Issuing bank. The buyer's bank, which gives the irrevocable undertaking to pay.
• Beneficiary. The seller, in whose favor the credit is issued.
• Advising bank. A bank, usually in the seller's country, that authenticates the credit and passes it to the seller.
• Confirming bank. A bank that adds its own undertaking to pay, so the seller is protected even if the issuing bank or its country cannot pay.
• Nominated bank. A bank authorized to pay, accept a draft or negotiate under the credit.

1. Buyer and seller agree in the sales contract that payment will be by LC, often after exchanging a pro forma invoice.
2. The buyer applies to its bank, which issues the credit and sends it, usually by SWIFT message, to an advising bank.
3. The seller ships the goods and assembles the required documents, typically a commercial invoice, a bill of lading or other transport document, an insurance certificate, a packing list and a certificate of origin.
4. The seller presents the documents to the nominated or confirming bank, which examines them. Under the rules most commonly used, a bank has a maximum of five banking days after presentation to decide whether the presentation complies.
5. If the documents comply, the bank pays or undertakes to pay at a later date, and forwards the documents to the issuing bank, which reimburses it and releases the documents to the buyer in exchange for payment or under a financing arrangement.
6. The buyer uses the documents, notably the bill of lading as a document of title, to collect the goods.

Most letters of credit are expressly issued subject to the Uniform Customs and Practice for Documentary Credits, published by the International Chamber of Commerce (ICC). The current version, UCP 600, took effect on 1 July 2007. It establishes the independence principle, under which the credit is separate from the sales contract, and the rule that banks deal with documents, not goods. Supporting ICC publications include the International Standard Banking Practice (ISBP) for document examination and the eUCP for electronic presentations. Standby credits are often issued under ISP98. National law still governs matters the rules do not cover, notably fraud.

• Sight and usance credits. A sight credit pays on compliant presentation; a usance or deferred-payment credit pays at a later date, often supported by a bill of exchange accepted by the bank.
• Confirmed credits. Add a second bank's undertaking, commonly where the issuing bank or country carries significant risk.
• Transferable and back-to-back credits. Allow an intermediary to pass the benefit of a credit to its own supplier.
• Standby letters of credit. Function as a guarantee, paying only if the applicant fails to perform.

Trade payment methods are often ranked by risk. Cash in advance is safest for the seller and riskiest for the buyer; open-account trade is the reverse. A letter of credit and a documentary collection sit in between, but only the LC carries a bank's payment undertaking. LCs are more expensive and paperwork-intensive, so their share of world trade has declined as trading relationships and supply chain finance have matured, although they remain important in commodities and in trade with higher-risk markets. The choice interacts with supplier-payment terms and with the delivery terms set by Incoterms.

A large share of first presentations are found discrepant, for example because of a late shipment, inconsistent descriptions or a missing signature. The issuing bank may then refuse payment or ask the applicant to waive the discrepancies. When goods arrive before the documents, carriers may release cargo against a letter of indemnity rather than the original bill of lading.

Letters of credit are also used in trade-based money laundering and fraud, with forged or recycled documents supporting fictitious or over-invoiced shipments. Banks apply trade authenticity verification, vessel tracking and sanctions screening. The move to the electronic bill of lading and digital presentations aims to reduce delays and document fraud.

• International Chamber of Commerce