Letter of credit (LC): how it works, the types, and the full process

A letter of credit lets two companies who have never met, in two countries with different courts and languages, trade without either one taking a leap of faith. It works by swapping one question for another. Instead of the seller asking "can I trust this buyer to pay me?", the seller only has to ask "can I trust this buyer's bank?". That is a much easier question, and it is the entire reason the LC exists.

Here is how a letter of credit works, start to finish: what it is, who the banks are, how the process flows step by step, every common type (sight, usance, confirmed, unconfirmed, freely negotiable, restricted, red clause, back to back, transferable, standby, and more), the bill of exchange, the documents, how to read the LC's key fields, and where the costs and traps hide. Two running examples keep it concrete:

• Import example (India buying): Bharat Tools Pvt Ltd in Vadodara imports CNC machines from Zhejiang Machinery Co in China. Bharat Tools is the buyer; the Chinese company is the seller.
• Export example (India selling): Surat Textiles Pvt Ltd exports fabric to Hudson Retail Inc in the USA. Surat Textiles is the seller; the US company is the buyer.

What is a letter of credit, in plain English?

A letter of credit (also called an LC, or "documentary credit") is a written promise from the buyer's bank to pay the seller a fixed amount of money, provided the seller presents a specific set of documents that match the conditions in the LC, within the deadlines it sets. The bank puts its own name and money on the line in place of the buyer's. So the seller stops depending on whether the buyer is honest or solvent, and starts depending only on the bank and on getting the paperwork right.

In the import example, Bharat Tools does not pay the Chinese seller upfront and hope the machines arrive. Instead Bharat Tools' bank issues an LC that says, in effect: "Dear Zhejiang Machinery, ship the CNC machines and give us a compliant bill of lading, invoice and packing list, and we the bank will pay you USD 200,000." Now the Chinese seller is relying on an Indian bank's promise, not on a company it has never met.

Internationally, almost every commercial LC follows one rulebook: the ICC's UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision). It sets out how banks read documents and settle disputes, and it carries the single most important rule in the whole system, which we will keep coming back to: banks deal in documents, not in goods. They never inspect the cargo. They pay if the papers are in order.

The parties: who is who

An LC has a small cast of characters. Learn them once and every LC diagram makes sense. Here they are, mapped to both examples.

Two terms confuse people: the presenting bank is simply whichever bank actually hands the seller's documents to the next bank in the chain (usually the seller's own bank). The negotiating bank is a nominated bank that not only forwards the documents but is willing to pay the seller early, before it has itself been reimbursed by the issuing bank. Whether a seller can use its own bank for this depends on whether the LC is "freely negotiable" or "restricted", which we get to below.

How a letter of credit works, step by step (the process flow)

Every documentary LC follows the same sequence. Here it is for the import example, Bharat Tools buying machines from China:

1. Agree the terms. Bharat Tools and Zhejiang Machinery sign a sales contract that says payment will be "by irrevocable letter of credit", and spell out the price, the goods, the shipment date and the documents required.
2. Apply for the LC. Bharat Tools fills in an LC application at its bank, stating the amount (USD 200,000), the beneficiary, the documents needed, the latest shipment date, and the expiry date. The bank checks Bharat Tools' credit and takes a margin.
3. Issue the LC. The Indian issuing bank sends the LC over the SWIFT network (as an MT700 message) to a bank in China.
4. Advise the LC. The Chinese advising bank confirms the message is genuine and passes the LC to Zhejiang Machinery.
5. Ship the goods. Zhejiang ships the machines on or before the latest shipment date and collects the transport document (an ocean bill of lading) from the shipping line.
6. Present the documents. Zhejiang assembles the exact documents the LC named, invoice, bill of lading, packing list, insurance (depending on the agreed Incoterm), certificate of origin, bill of exchange, and presents them to the nominated bank within the presentation period.
7. Examine the documents. The banks check the documents against the LC wording, not against the machines. They are looking for any mismatch.
8. Pay. If the documents comply, the seller is paid, straight away on a sight LC, or at the future maturity date on a usance LC.
9. Reimburse and release. The Indian issuing bank reimburses the paying bank, then releases the documents to Bharat Tools. Bharat Tools uses the bill of lading to take delivery of the machines and clear customs.

The export example is the mirror image. When Surat Textiles sells fabric to Hudson Retail in the USA, it is now the beneficiary: the US buyer's bank issues the LC, an Indian bank advises it to Surat, Surat ships and presents documents to its Indian bank, and gets paid once the documents are found compliant. Same mechanism, opposite seat.

The bill of exchange (draft) in an LC

Several searches land here asking how the bill of exchange fits into an LC, so let us be precise. A bill of exchange (also called a draft) is a short signed order written by the seller telling the bank to pay a stated sum. It is one of the documents the seller presents, and it is the instrument that formally demands payment.

• Under a sight LC, the seller draws a sight draft, an order to "pay on presentation". The bank pays now.
• Under a usance LC, the seller draws a usance (time) draft, an order to pay at a future date, say 90 days after the bill of lading date. The bank stamps it "accepted", which turns it into a bankers' acceptance: a dated, bank-backed promise to pay on maturity. That accepted draft is what the seller can later discount for early cash.

So the draft is both the payment demand and, in usance deals, the thing that carries the bank's dated promise. A documentary collection can also use a bill of exchange, but there the bank only forwards it, no bank guarantees payment, which is the key difference from an LC.

Sight vs usance: when do you actually get paid?

This is the first distinction to nail, because it decides your cash flow.

• Sight LC. The seller is paid as soon as compliant documents are presented (in practice within a few banking days). Best for the seller. In the export example, Surat Textiles would prefer a sight LC so cash comes in right after shipment.
• Usance LC (also called deferred or time LC). Payment happens on a future date, commonly 30, 60, 90 or 180 days after shipment or the bill of lading date. This gives the buyer a credit period to receive and even sell the goods before paying. A search like "l/c 60 days" simply means a usance LC with a 60 day tenor.

The tenor of an LC is just this credit period, "at sight", or "90 days from B/L date", and so on. On a usance LC the seller does not have to wait: it can discount the accepted draft with a bank and get most of the cash immediately, paying a discounting cost for the privilege (covered below). Usance LCs are where trade settlement starts to overlap with financing, and are exactly the kind of instrument that sits behind structures like buyer's credit.

Confirmed vs unconfirmed (and silent confirmation)

This distinction is about whose promise you are really relying on, and it drives a whole cluster of questions: confirmed LC, unconfirmed LC, LC confirmation, silent confirmation, the confirmation market.

An unconfirmed LC carries only the issuing bank's promise. If that bank is small, or sits in a country with currency, transfer or political risk, the seller is still exposed to that risk even though it holds an LC.

A confirmed LC adds a second, independent promise from a bank in the seller's own country, the confirming bank. That bank agrees to pay the seller whether or not the issuing bank ever pays it. Now the seller collects from a local bank it trusts, and the issuing bank and country risk fall away. In the export example, if Hudson Retail's bank were in a shaky jurisdiction, Surat Textiles would ask for an Indian bank to confirm the LC, so Surat gets paid by an Indian bank it can actually walk into.

• Confirmation is added at the request of the issuing bank (or beneficiary) and costs a fee that reflects the risk of the issuing bank's country.
• Silent confirmation is when the seller's bank confirms the LC without the issuing bank's involvement or knowledge, usually because the issuing bank would not authorise it. It gives the seller the same protection at a (often higher) fee, arranged privately.
• The confirmation market is simply banks pricing and trading this risk: what it costs to add a guarantee on a given issuing bank in a given country.
• Note that "irrevocable" and "confirmed" are not the same. Irrevocable means the LC cannot be changed or cancelled without everyone's agreement (essentially all LCs today are irrevocable). Confirmed means a second bank has added its guarantee. An LC can be irrevocable and unconfirmed.

An unconfirmed LC is only as good as the issuing bank and its country. Confirmation turns it into the promise of a bank you can actually reach, which is why exporters insist on it when selling into a risky market.

Freely negotiable vs restricted (which bank can you use?)

This pair answers "freely negotiable letter of credit", "restricted LC", "unrestricted LC" and "LC negotiation". It is about which bank is allowed to handle and pay against your documents.

• Restricted LC. The LC is available only with one named bank (the nominated bank). The seller must route its documents through that specific bank, even if it is not the seller's own bank. Less convenient, and sometimes means an extra bank in the chain.
• Freely negotiable (unrestricted) LC. The LC is available with any bank. The seller can present through its own bank, which is faster and usually cheaper. In the LC's SWIFT fields this shows up as "available with any bank by negotiation".

Negotiation itself means a nominated bank buying (advancing against) the seller's compliant documents before it has been reimbursed by the issuing bank, giving the seller cash sooner. So a "freely negotiable" LC that is also "sight" is about the friendliest structure a seller can get: any bank, paid quickly.

The main types of letter of credit

Beyond the three axes above, LCs come in named flavours. Most are just a standard documentary credit with one special feature bolted on.

You may also see "conditional" and "direct" LCs described. A conditional letter of credit is loose language for a credit that pays only when extra conditions are met (technically every documentary LC is conditional, it pays against conditions). A direct LC usually means one payable directly by the issuing bank without an intermediary negotiating bank. These are descriptions of behaviour, not separate legal instruments.

The documents: to open an LC, and to get paid

Two different document sets matter, and people mix them up. One set opens the LC (the buyer's side); the other set gets the seller paid (the beneficiary's side).

Documents to open an import LC (buyer's side)

When Bharat Tools opens the LC, its bank typically wants:

• The bank's LC application / opening form, filled with amount, tenor, beneficiary and documents.
• The sales contract or proforma invoice from the seller.
• Import Export Code (IEC) and any import licence details (India).
• Arrangement of the LC limit and margin with the bank (often a percentage of the LC value held as margin).
• Insurance arrangements if the LC terms require the buyer to insure.

Documents the seller presents to get paid (beneficiary's side)

These are named inside the LC. A typical list:

• Commercial invoice, describing the goods exactly as the LC does.
• Transport document, an ocean bill of lading or an airway bill, showing shipment on time.
• Packing list, contents, weights and marks.
• Insurance certificate or policy, if the seller insures.
• Certificate of origin, where the goods were made.
• Bill of exchange (draft), the payment order, at sight or usance.
• Any special certificates the LC asks for: inspection, weight, phytosanitary, and so on.

Reading an LC: the key fields (MT700)

An LC arrives as a structured SWIFT message with numbered fields, and a lot of specific searches ("letter of credit 39A", "43P in LC", "place of taking charge in LC", "LC clauses UCP 600", "LC expiry date") are really people trying to read those fields. Here are the ones that matter, in plain terms.

You do not need to memorise these. But knowing that 41a decides restricted vs freely negotiable, 42C sets sight vs usance, 44C is your shipment deadline, and 31D is your expiry, means you can read the four fields that actually govern whether you get paid.

Discrepancies: where LCs actually go wrong

Because banks pay against documents, a discrepancy, any mismatch between the documents and the LC, or an inconsistency between the documents themselves, gives the issuing bank the right to refuse payment. At that moment a "guaranteed" sale becomes an ordinary unsecured one, at the buyer's mercy. A meaningful share of first presentations are discrepant on the first pass, almost always for mundane reasons:

• Late shipment, or documents presented after the presentation period or after LC expiry.
• The goods description on the invoice not matching the LC wording (field 45A).
• An amount over or under what the LC and its tolerance (39A) allow.
• Data that disagrees across documents: weights, marks, dates that do not tally.
• Missing endorsements on the bill of lading, or insurance in the wrong form or value.
• Plain typos, a misspelt name or wrong reference that breaks an exact match.

Getting cash early: LC discounting

On a usance LC the seller does not have to wait out the credit period. Once the bank has accepted the draft, the seller can discount it: the bank pays most of the face value now and collects the full amount at maturity, keeping the difference as interest. So a 90 day usance LC can become cash in hand within days, at a discounting cost. This is often called LC bill discounting, and it is how exporters turn a future-dated bank promise into working capital today, similar in spirit to how packing credit (PCFC) funds the period before shipment.

Trust receipt: taking the goods before paying

On the buyer's side, a trust receipt solves a timing problem. Under a usance LC the buyer may need the goods (to sell or use) before the payment date arrives. The bank releases the documents against a signed trust receipt, in which the buyer acknowledges the bank still owns the goods (or their sale proceeds) until the LC is paid. So Bharat Tools could clear and sell the machines, then repay its bank from the proceeds on the due date. A trust receipt is a financing bridge, not a payment method, which is the key difference from an LC itself.

Where the costs hide

An LC is rarely quoted as a single number, which is exactly why people underestimate it. The charges stack up on both sides:

• Issuance / opening commission (buyer): usually a percentage of the LC value, charged per quarter or part thereof.
• Advising fee: the advising bank's charge to authenticate and pass on the LC.
• Confirmation charges: if confirmed; can be significant for risky countries.
• Negotiation / handling charges: for examining and processing documents.
• Discrepancy fee: a flat charge deducted for each discrepant presentation. Sloppy documents literally cost you per mistake.
• Amendment charges: every change to the LC after issuance.
• Acceptance commission plus discounting interest: on a usance LC, if you discount the accepted bill for early cash.
• Reimbursement charges: between the banks in the settlement chain.

The true cost of trading on an LC is the sum of all of these across both parties. Cost it before you agree to LC terms, not after, the same "read the all-in, not the headline" discipline I apply to buyer's credit.

LC vs the alternatives

An LC sits in the middle of a spectrum of payment terms, traded off against how much the two sides trust each other:

• Advance payment: best for the seller, worst for the buyer; used when trust is low or the buyer has little leverage.
• Open account: best for the buyer, riskiest for the seller; goods ship and payment follows on trust.
• Documentary collection: cheaper than an LC; the bank handles documents against payment or acceptance, but gives no guarantee of payment.
• Letter of credit: a bank guarantee, more secure than collection, but the most expensive and document-intensive.

The right choice depends on counterparty trust, country risk and bargaining power, not on habit. As a relationship matures, parties often move from LCs towards open account to cut cost and friction.

Practical discipline

If you are going to trade on LCs, a few habits prevent almost all the pain:

• Negotiate the LC's required documents and dates into the sales contract. Never accept an LC you cannot comply with.
• Read the LC the moment it is advised; request amendments early, while there is still time.
• Diarise the three dates that matter: latest shipment date (44C), presentation period (48), and expiry (31D).
• Present documents that mirror the LC wording exactly. Treat it as a matching exercise, not a writing one.
• For shipments to higher-risk markets, ask for confirmation and price it into the deal.

For all its machinery, an LC comes down to one habit: present documents that match the credit, on time. Get that right and you can sell to a stranger across a border and still be paid. Get it wrong and the guarantee you paid for simply does not pay.

Frequently asked questions

What is a letter of credit in simple words?

It is the buyer's bank promising, in writing, to pay the seller a set amount if the seller hands over the exact documents the LC asks for, on time. The bank's promise replaces the buyer's, so the seller only has to trust the bank.

What is the difference between sight and usance LC?

A sight LC pays the seller as soon as compliant documents are presented. A usance LC pays on a later date (for example 60 or 90 days after shipment), giving the buyer a credit period; the seller can discount the accepted draft for early cash.

What does a confirmed LC mean?

It means a second bank, usually in the seller's country, has added its own guarantee to pay, on top of the issuing bank's. The seller is then protected even if the issuing bank or its country fails to pay.

What is a freely negotiable letter of credit?

One that any bank may handle and pay against, so the seller can use its own bank. A restricted LC is available only with one named bank.

What is a bill of exchange under an LC?

A signed order from the seller telling the bank to pay a stated sum, at sight or at a future date. It is one of the presented documents, and on usance LCs the accepted draft is what gets discounted for early payment.

What is a red clause LC?

An LC that lets the seller draw a pre-shipment advance before shipping the goods, to fund production. The advance is adjusted against the final LC payment.

What is a trust receipt in an LC?

A document that lets the buyer take the goods before paying the bank, while the bank retains title until the LC is settled, so the buyer can sell the goods and repay from the proceeds.

Note: This article is a general explainer on how letters of credit work. It is not legal or financial advice. LC terms, applicable rules and bank charges vary by transaction and institution; confirm the specifics of any credit with your banker before relying on it.