What Is a Letter of Credit?
Understand how letters of credit provide payment guarantees in international trade, reducing risk for both importers and exporters.
Key Takeaways
- A letter of credit is a bank-issued guarantee that the seller will receive payment if shipping documents meet agreed terms.
- LCs are governed by the ICC Uniform Customs and Practice for Documentary Credits (UCP 600).
- Confirmed LCs add a second bank guarantee, which is critical for exporters in higher-risk markets.
Definition of a Letter of Credit
A letter of credit (LC) is a written commitment from a bank, issued on behalf of the buyer, guaranteeing that the seller will receive payment provided they present documents that comply with the LC terms. It shifts the payment risk from the buyer to the issuing bank. LCs are one of the oldest and most trusted instruments in international trade, governed internationally by UCP 600 rules published by the International Chamber of Commerce.
Types of Letters of Credit
Several LC variants serve different purposes. A sight LC requires immediate payment upon document presentation. A usance LC allows deferred payment, typically 30-180 days after shipment. A confirmed LC adds a second bank's guarantee, providing extra security when the issuing bank is in a country with elevated risk. Standby LCs function as backup guarantees, activated only if the buyer defaults. Revolving LCs cover repeated shipments without requiring a new LC each time.
The LC Process Step by Step
The buyer and seller agree on LC terms in their sales contract. The buyer applies to their bank (the issuing bank) to open the LC. The issuing bank sends the LC to the seller's bank (the advising bank). The seller ships the goods and presents compliant documents. The advising bank checks documents and forwards them to the issuing bank, which releases payment. Each step involves strict document verification to prevent fraud.
Letters of Credit in African Trade
For African exporters, LCs provide critical assurance when dealing with unfamiliar buyers. A Nigerian cocoa exporter, for instance, can ship to a European buyer knowing that payment is backed by a reputable bank rather than relying solely on the buyer's promise. However, LC costs can be significant, typically 1-3% of the transaction value, which is why many African SMEs seek alternatives like trade credit insurance for lower-value shipments.