Letter of credit, explained — how an LC actually works

A letter of credit is the instrument that lets two companies who have never met, in two countries with different legal systems, trade safely with each other. It does this by swapping the question "do I trust this buyer?" for "do I trust this buyer's bank?". For the exporter it's a payment guarantee; for the importer it's leverage to receive goods without paying upfront. But an LC is also a documents game with its own rulebook — and the businesses that lose money on LCs almost always lose it the same way: on a discrepancy that lets the bank refuse to pay.

Here's how an LC works end to end — the parties, the document flow, the main types (sight vs usance, confirmed vs unconfirmed), where the costs hide, and the discrepancy discipline that decides whether the guarantee is real or just paperwork.

What an LC is — a bank's conditional promise

A letter of credit is an irrevocable undertaking by the importer's bank (the issuing bank) to pay the exporter (the beneficiary) a stated sum — provided the exporter presents documents that comply, on their face, with the terms of the credit. The bank substitutes its own creditworthiness for the buyer's. That's the whole magic: the exporter no longer depends on the buyer's willingness or ability to pay, only on presenting the right documents.

Internationally, LCs run on the ICC's UCP 600 — the Uniform Customs and Practice for Documentary Credits. It governs how banks examine documents and settle disputes, and it underpins the single most important principle in the whole mechanism, which we'll come to: banks deal in documents, not goods.

The document flow, step by step

An LC transaction follows a predictable sequence:

1. Sales contract. Buyer and seller agree commercial terms, including "payment by letter of credit" and what the LC must require.
2. Application. The importer applies to its bank to open an LC in the exporter's favour, specifying amount, documents, latest shipment date, and expiry.
3. Issuance. The issuing bank issues the LC (today over SWIFT) and routes it through an advising bank in the exporter's country.
4. Advising. The advising bank authenticates the LC and advises it to the exporter.
5. Shipment. The exporter ships the goods on or before the latest shipment date in the LC.
6. Presentation. The exporter assembles the required documents — commercial invoice, transport document (bill of lading / airway bill), packing list, insurance, certificate of origin, bill of exchange, and any others the LC names — and presents them to the nominated bank within the presentation period.
7. Examination. The banks examine the documents against the LC terms — not the goods themselves.
8. Payment. If the documents comply: a sight LC pays immediately; a usance LC creates an accepted obligation payable at maturity.
9. Reimbursement & release. The issuing bank reimburses, releases the documents to the importer, who uses the transport document to take delivery and clear the goods.

Sight vs usance — when you actually get paid

This is the first big distinction:

• Sight LC. Payment is made on presentation of compliant documents — effectively immediate. Best for the exporter's cash flow.
• Usance (deferred) LC. Payment is made at a future date — say 90 or 180 days after the shipment or bill-of-lading date. This gives the importer a credit period. The exporter can still get cash early by discounting the accepted bill with a bank (often called LC bill discounting), turning a future-dated guarantee into present cash for a discounting cost.

Usance LCs are where trade finance starts to overlap with funding. A usance LC backed by a bank's acceptance is exactly the kind of instrument that sits behind structures like buyer's credit — short-term financing layered on top of the trade document.

Confirmed vs unconfirmed — whose promise are you relying on?

An unconfirmed LC carries only the issuing bank's undertaking. If that bank is small, or sits in a country with payment, transfer, or political risk, the exporter is exposed to that risk despite holding an LC.

A confirmed LC adds a second guarantee: a bank in the exporter's own country (the confirming bank) undertakes to pay independently of the issuing bank. Now the exporter collects from a local bank it trusts, and the issuing-bank and country risk fall away. Confirmation costs a fee — but for shipments to higher-risk geographies, it's often the difference between a real guarantee and a paper one.

An unconfirmed LC is only as good as the issuing bank and its country. Confirmation converts that into the promise of a bank you can actually reach — which is the whole point of asking for an LC in a risky market.

The other flavours, briefly

• Revolving LC — reinstates automatically for repeat shipments under an ongoing supply relationship, so you don't open a fresh LC each time.
• Transferable LC — lets the beneficiary transfer part of the credit to a second beneficiary (useful for intermediaries and traders).
• Back-to-back LC — a second LC opened on the strength of a first, common when a trader buys from a supplier to fulfil a buyer's order.
• Standby LC (SBLC) — fundamentally a guarantee, not a payment mechanism: it only pays if the applicant defaults. SBLCs back obligations (including trade credit) rather than settling each shipment, which makes them quite different in spirit from a documentary LC.

Discrepancies — where LCs actually go wrong

Here is the principle that decides everything: under UCP 600, banks deal in documents, not goods. They never see the cargo. They pay if the documents match the credit. So a discrepancy — any mismatch between the documents and the LC terms, or an inconsistency between the documents themselves — gives the issuing bank the right to refuse payment. At that moment your "guaranteed" sale becomes an unsecured one, at the buyer's mercy.

The common discrepancies are mundane and entirely avoidable:

• Late shipment, or documents presented after the presentation period or LC expiry.
• Goods description on the invoice not matching the LC wording.
• Amounts that exceed (or fall short of) what the LC allows.
• Inconsistent data across documents — weights, marks, dates that don't agree.
• Missing endorsements on the transport document, or insurance not in the required form/value.
• Plain typos — a misspelt name or wrong reference that breaks an exact match.

A meaningful share of first presentations are discrepant on the first pass. The fix is unglamorous and reliable: read the LC the day it's advised, build a checklist from it, and present documents that mirror the credit's language word for word.

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 of the deal:

• Issuance / opening commission (importer) — 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, since the confirming bank is taking real risk.
• 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 + 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 genuine cost of trading on an LC is the sum of all of these across both parties — the same "read the all-in, not the headline" discipline I apply to buyer's credit. Cost it before you agree to LC terms, not after.

LC vs the alternatives

An LC is the middle of a spectrum of payment terms, traded off against how much you trust the counterparty:

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

The right choice is a function of counterparty trust, country risk, and bargaining power — not a default. As a relationship matures, parties often migrate from LCs toward open account to cut cost and friction.

Practical discipline

If you're 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 can't comply with.
• Review the LC the moment it's advised; request amendments early, while there's still time.
• Diarise the three dates that matter: latest shipment date, presentation period, and expiry.
• 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.

Done with discipline, an LC is one of the most elegant instruments in trade: it lets you sell to a stranger across a border and still get paid. Done carelessly, it's an expensive way to discover that a bank's promise was conditional all along.

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.