A letter of credit is a bank undertaking to honor a complying documentary presentation under the credit's stated terms.
A letter of credit (LC), also called a documentary credit, is a bank’s undertaking to pay, accept, or negotiate in favor of a beneficiary when the beneficiary makes a complying presentation under the credit’s terms. The bank examines the required documents, not the physical goods or services. Payment can therefore be refused for documentary discrepancies even when goods were shipped, while a complying presentation can require honor despite a separate commercial dispute.
| Party | Role in a typical commercial LC |
|---|---|
| Applicant | Usually the buyer or importer that requests issuance and agrees to reimburse the issuing bank |
| Beneficiary | Usually the seller or exporter entitled to present documents and draw under the credit |
| Issuing bank | Issues the credit and undertakes to honor a complying presentation under its terms |
| Advising bank | Advises the credit and checks its apparent authenticity without automatically adding a payment undertaking |
| Nominated bank | Bank with which the credit is available, or a bank authorized to act as stated in the credit |
| Confirming bank | Adds its own undertaking when authorized or requested and when it agrees to confirm |
A bank can perform more than one role, but the role must be proved by the issued credit, authenticated message, advice, confirmation, or other bank record. A beneficiary-side bank is not automatically a confirming bank merely because it receives documents.
flowchart LR
A["Buyer and seller agree contract"] --> B["Applicant requests LC"]
B --> C["Issuing bank issues LC"]
C --> D["Advising bank advises beneficiary"]
D --> E["Beneficiary ships or performs"]
E --> F["Beneficiary presents required documents"]
F --> G{"Complying presentation?"}
G -->|"Yes"| H["Bank honors or negotiates as stated"]
G -->|"No"| I["Discrepancy notice, correction, or possible waiver"]
H --> J["Applicant reimburses issuing bank"]
The diagram is illustrative. Confirmation, deferred payment, reimbursement banks, document routing, financing, and sanctions review can add steps. The operative credit and incorporated rules control.
The independence principle separates the credit from the underlying sale. Under UCP 600, banks deal with documents rather than the goods, services, or performance to which those documents relate. This has two practical effects:
Common required documents can include a commercial invoice, transport document, packing list, insurance document, certificate of origin, or inspection certificate. There is no universal document package. Every required document adds information but also creates another opportunity for conflict, lateness, ambiguity, or fraud.
| Structure | What it changes | Important distinction |
|---|---|---|
| Sight payment | Payment is due when a complying presentation is honored at sight | “At sight” does not mean before document examination |
| Deferred payment | Bank incurs an undertaking payable at a stated future maturity | Beneficiary may still face timing and financing risk |
| Acceptance | Bank accepts a qualifying draft and pays at maturity | Draft and maturity terms must match the credit |
| Negotiation | A nominated bank purchases drafts or documents under the stated terms | Nomination alone does not always obligate a bank to negotiate |
| Confirmed credit | Another bank adds its own undertaking | Advising without confirmation adds no equivalent undertaking |
| Transferable credit | Permits availability to one or more second beneficiaries under the rules and credit | The credit must specifically state that it is transferable |
| Back-to-back credits | Uses one credit to support issuance of a separate credit | Each credit has its own issuer, beneficiary, terms, and presentation risk |
| Standby letter of credit | Supports payment or performance if the applicant fails | Usually a secondary remedy rather than the ordinary payment route |
Assume an importer agrees to buy pump equipment for $250,000. Its bank issues a UCP 600 letter of credit with these simplified terms:
$250,000;The exporter ships on September 28 and presents the required documents on October 3. If the documents appear on their face to comply, the applicable bank follows the credit’s sight-payment process. The bank does not open the containers or test the pumps.
Now assume the commercial invoice and packing list describe 50 pump units, but the certificate of origin describes 48. That conflict can create a discrepancy. The bank may refuse to honor in accordance with the applicable rules and notice process. The issuing bank may seek an applicant waiver, but the exporter should not treat a waiver as automatic or wait for one if correction is still possible before expiry.
The example shows the LC’s central tradeoff: bank payment support is tied to documentary compliance, not a broad conclusion that the seller performed the sales contract perfectly.
| Perspective | Risks reduced | Risks that remain or increase |
|---|---|---|
| Beneficiary | Applicant nonpayment after a complying presentation | Document discrepancy, issuing-bank risk, country or transfer restrictions, fraud review, expiry, and fees |
| Applicant | Payment is conditioned on the stated documentary presentation | Banks do not verify quality or physical conformity; reimbursement and collateral obligations remain |
| Issuing bank | Documentary conditions and applicant reimbursement agreement structure the exposure | Applicant credit, document examination, sanctions, fraud, operational, country, and reimbursement risk |
| Confirming or nominated bank | Defined role and document process | Issuing-bank, country, documentary, timing, and role-specific exposure |
An LC is not universally safer or cheaper than open-account terms, documentary collection, export credit insurance, or cash in advance. The appropriate method depends on bargaining power, transaction value, relationship, market risk, document availability, financing needs, and cost.
This article provides general financial education, not legal, banking, sanctions, accounting, or transaction advice. The issued credit, incorporated rules, bank agreements, governing law, and transaction facts control.