Letter of credit (documentary credit)
A letter of credit, also called a documentary credit, is a bank's undertaking to pay a seller a stated amount if the seller presents documents that comply with the credit's terms. It replaces the buyer's credit risk with a bank's and is usually subject to the ICC rules UCP 600. A confirmed credit adds a second bank's undertaking.
Roles that need it
What it is
A letter of credit (LC), also called a documentary credit, is a bank’s written undertaking to pay a seller (the beneficiary) a stated amount, provided the seller presents documents that comply with the terms of the credit. The buyer (the applicant) asks its bank (the issuing bank) to open the credit. A bank in the seller’s country often advises it, and may add its own undertaking, called confirmation. Most LCs are subject to the International Chamber of Commerce rules UCP 600, in use since 2007. Common types are sight credits (payment on compliant presentation), deferred payment and acceptance credits (payment at a later date), and transferable credits.
Why it matters
An LC replaces the buyer’s credit risk with a bank’s. The seller gets paid if its documents comply, even if the buyer changes its mind, and the buyer knows payment happens only against documents showing shipment. Banks deal in documents only and do not inspect the goods. This makes LCs useful in trade with new partners, distant markets or countries with high risk. For banks, LCs generate fee income, use credit limits for the applicant and require sanctions and trade-based money laundering checks on parties, goods, vessels and ports.
Worked example
Illustrative numbers. An importer in Rotterdam buys machine parts worth 200,000 euro from a manufacturer in Izmir. Its bank issues an LC payable at sight against an invoice, a packing list, a bill of lading and a certificate of origin, with latest shipment on 15 March and expiry on 5 April. The seller ships on 10 March and presents the documents on 20 March. The issuing bank has at most five banking days after presentation to decide whether they comply. It finds them compliant and pays 200,000 euro. Its fees are 0.15% for issuance (300 euro) plus a fixed charge for document checking. Had the bill of lading shown shipment on 18 March, the documents would be discrepant and the bank could refuse them.
Who uses it
Trade finance analysts (CORPBANK-TRADE) structure LCs and assess the credit risk of applicants. Trade finance operations specialists (LOANOPS-TF) issue and amend credits and examine documents under UCP 600. Transaction banking analysts (CORPBANK-TXB) price and package trade services. Transaction banking sales (PCMSALES) offer trade solutions to corporate clients. Relationship managers (CORPBANK-REL) approve limits and discuss trade needs with clients. Sanctions analysts (AML-SANC) screen parties, goods and shipping data.
Common confusions
A commercial letter of credit pays for the trade itself, while a standby letter of credit or a demand guarantee pays only if the applicant fails to perform. A confirmed LC adds a second bank’s undertaking, which protects the seller against the issuing bank and its country; an LC that is only advised gives no such protection. An LC is also different from a documentary collection, where banks handle documents without promising payment. Finally, compliance is judged on the face of the documents: small differences, such as a wrong date, can be enough for refusal.