What is a letter of credit?
A letter of credit (LC) is a written guarantee issued by a bank on behalf of the buyer. It promises to pay the seller a set amount of money, provided the seller presents documents that match the LC terms exactly. The bank pays, not the buyer directly. That guarantee is what makes letters of credit one of the safest ways to settle payment in international trade.
If a buyer in another country has asked you to ship goods on a letter of credit, or your supplier is demanding one before they will produce your order, this article explains how it all works, in plain English.
Letters of credit can feel complicated the first time you encounter them. There are multiple banks, a long list of required documents, strict deadlines, and a rule set that penalises even small typos. But the underlying idea is simple: a bank stands between the buyer and seller and guarantees payment, as long as the seller does exactly what they said they would.
This article walks you through every stage of the process, from the moment an LC is opened to the moment payment lands in the exporter’s account.
A letter of credit is a financial instrument issued by the buyer’s bank. It instructs the seller’s bank to pay the seller a specified sum, on condition that the seller presents a specific set of documents within a set timeframe.
The key word is “conditional.” The bank is not promising to pay no matter what. It is promising to pay if the seller meets every condition spelled out in the LC.
Letters of credit are governed by the UCP 600: the Uniform Customs and Practice for Documentary Credits, published by the International Chamber of Commerce (ICC). UCP 600 came into force in 2007 and is the global rulebook for how LCs operate. UK banks use UCP 600, and it applies to LCs issued under English law just as it does everywhere else. Post-Brexit, the mechanics of letters of credit in the UK are unchanged.
The formal name used in banking is documentary credit, because it is a credit facility that works through documents. You will see both terms used interchangeably.
Here is the full sequence of events, from contract to payment.
Step 1: Buyer and seller agree terms. The sales contract specifies that payment will be made by letter of credit. It names the LC type, the currency, the amount, and what documents the seller must produce.
Step 2: Buyer applies to their bank. The buyer (called the applicant) goes to their bank (the issuing bank) and applies for a letter of credit. The bank checks the buyer’s credit history and, if satisfied, issues the LC. The buyer pays an issuance fee, typically 0.5%–1% of the LC value.
Step 3: Issuing bank sends the LC to the advising bank. The issuing bank transmits the LC to a bank in the seller’s country (the advising bank). The advising bank checks the LC is genuine and passes it to the seller (the beneficiary).
Step 4: Seller reviews the LC carefully. This is critical. Before shipping anything, the seller reads every word of the LC. If the terms cannot be met, wrong shipment date, impossible document requirements: the seller must ask for an amendment now, not after shipment.
Step 5: Seller ships the goods. Once the seller is satisfied the LC terms are achievable, they ship the goods. The shipping creates the key document: the bill of lading (or airway bill, for air freight).
Step 6: Seller gathers all required documents. The seller collects every document named in the LC, commercial invoice, bill of lading, packing list, certificate of origin, insurance certificate, and any others specified. Every detail must match the LC exactly.
Step 7: Seller presents documents to their bank. The seller presents the document set to the advising bank (or confirming bank, if there is one) within the deadline stated in the LC.
Step 8: Bank checks the documents. The bank examines the documents against the LC terms, line by line. Under UCP 600, banks have five banking days to complete this check.
Step 9, If documents comply, the bank pays. If the documents are clean, the bank pays the seller, either immediately (sight LC) or on a future date (usance LC). The bank then sends the documents to the issuing bank for reimbursement.
Step 10: Issuing bank releases documents to buyer. The issuing bank charges the buyer’s account and releases the shipping documents. The buyer uses the bill of lading to collect the goods from the port.
LC process, simplified flow:
Buyer → [1. Applies for LC] → Issuing Bank
Issuing Bank → [2. Issues LC via SWIFT] → Advising Bank
Advising Bank → [3. Notifies LC] → Seller
Seller → [4. Ships goods, presents documents] → Advising Bank
Advising Bank → [5. Checks documents, pays seller] → Seller
Advising Bank → [6. Claims reimbursement] → Issuing Bank
Issuing Bank → [7. Debits buyer, releases documents] → Buyer
Buyer → [8. Collects goods with documents] → Port/Carrier
Applicant (the buyer)
The company that instructs their bank to open the LC. They are the importer. They pay the bank fees and ultimately reimburse the issuing bank once documents are accepted.
Beneficiary (the seller)
The company that will receive payment. They are the exporter. The LC is issued in their favour. Payment is only triggered when they present complying documents.
Issuing bank (the buyer’s bank)
The bank that issues the LC and provides the payment guarantee. If the buyer cannot pay, the issuing bank still has to honour the LC, that is what makes the guarantee valuable. UK importers typically use their UK high street or trade finance bank as the issuing bank.
Advising bank (the seller’s bank)
A bank in the seller’s country that receives the LC from the issuing bank and passes it to the seller. The advising bank does not guarantee payment, it simply authenticates and communicates the LC. It may also be nominated as the bank where documents must be presented.
Confirming bank
An optional fifth party. If the seller does not trust the issuing bank (perhaps because they are in a high-risk country), they can ask for the LC to be “confirmed” by a bank in their own country. The confirming bank adds its own independent payment guarantee. This gives the seller double protection, both banks are obligated to pay if documents comply.
| LC Type | What It Means | When Used |
|---|---|---|
| Revocable | Can be cancelled or amended by the buyer’s bank at any time without telling the seller. Offers the seller almost no protection. | Rarely used in practice. Effectively obsolete under UCP 600. |
| Irrevocable | Cannot be cancelled or amended without agreement from all parties, including the seller. Offers real protection. | The standard in modern trade. All LCs under UCP 600 are irrevocable by default. |
| Confirmed | The seller’s own bank adds its payment guarantee on top of the issuing bank’s guarantee. | When the seller is worried about the issuing bank’s reliability or the buyer’s country risk (e.g., political instability, sanctions risk). |
| Sight LC | Payment is made immediately when the seller presents complying documents. | When the seller needs cash quickly. Most common type for standard trade transactions. |
| Usance LC (term or deferred) | Payment is made on a fixed future date — for example, 60 days after the date of the bill of lading. | When the buyer needs time to sell the goods before paying. Also called a “term LC.” Common in commodity trade. |
| Standby LC | Acts more like a bank guarantee than a trading payment tool. Payment is only triggered if the applicant fails to fulfil an obligation. | Used as a performance bond or credit support tool. Common in US markets and for service contracts. Different in purpose to a commercial LC. |
The LC spells out exactly which documents the seller must present. A typical international trade LC requires:
Commercial invoice
Issued by the seller. Shows the buyer, seller, goods description, quantity, unit price, total value, and Incoterm. The description of goods on the invoice must match the LC word for word.
Bill of lading (B/L)
Issued by the shipping line. Proves the goods were shipped. For an LC, this is usually a “full set” of original bills of lading (typically three originals). The bill of lading is the title document, whoever holds it can claim the goods.
Packing list
A detailed breakdown of the shipment, number of boxes or pallets, individual item quantities, weights, and dimensions. Must be consistent with the invoice and B/L.
Certificate of origin
Confirms the country where the goods were manufactured. Required for customs purposes in many markets and to claim preferential tariff rates under trade agreements. In the UK, this is often issued by a Chamber of Commerce.
Insurance certificate or policy
Required if the Incoterm places the insurance obligation on the seller (such as CIF or CIP). Shows the goods are insured for the voyage, usually for 110% of the invoice value.
Inspection certificate
Sometimes required by the buyer or the buyer’s country’s import regulations. A third-party surveyor inspects the goods before shipment and issues a certificate confirming they match the contract specification.
Other documents
Depending on the goods and destination: phytosanitary certificates (for agricultural produce), health certificates (for food and animal products), weight certificates, or a specific bank draft.
The LC lists every document required, the exact number of originals and copies, and how each document must be worded. The seller must produce all of them before the presentation deadline.
This is the most important concept to understand about letters of credit.
Banks do not look at the goods. They do not care whether the shipment is on time, whether the buyer is happy, or whether the seller has done everything the contract required. Banks deal in documents only.
Under UCP 600, banks must check whether documents comply “on their face” with the terms of the LC. This is known as the strict compliance standard. Documents must match the LC terms exactly.
What counts as a discrepancy? Examples include:
None of these seem catastrophic. But any one of them creates a discrepancy, and a discrepancy means the bank is no longer obligated to pay.
The lesson for exporters: read the LC before you ship. Read it again after you have your documents. Check every word.
When a bank finds a discrepancy, it issues a formal notice of discrepancy to the presenter (the seller or their bank). The bank will not pay until the discrepancy is resolved.
The seller then has a few options.
Option 1: Correct the documents. If the presentation deadline has not passed, the seller can fix the error and re-present. This is only possible if the document itself can be corrected (e.g., a new invoice can be issued) and there is time remaining.
Option 2, Ask the buyer to waive the discrepancy. The seller’s bank contacts the issuing bank, which contacts the buyer. If the buyer agrees to waive the discrepancy, the issuing bank is authorised to pay. But the buyer has no obligation to agree, and this gives the buyer use to renegotiate the price or delay payment.
Option 3: Accept payment under reserve or indemnity. Some banks will pay the seller under reserve, meaning the seller gets the money but agrees to return it if the issuing bank refuses to honour the LC. This transfers the discrepancy risk back to the seller.
Option 4: Hold the documents until a waiver is confirmed. The safest option for the seller. No money moves until the discrepancy is formally waived.
The industry-wide discrepancy rate is striking: around 70% of first presentations contain at least one discrepancy. This is not a niche problem, it is the norm. Most discrepancies are administrative, not deliberate. The strict compliance rule is simply unforgiving.
Letters of credit involve multiple fee events. Both the buyer and seller typically pay charges to their respective banks. Here are the main costs in a UK context.
Issuance fee (buyer’s cost)
Charged by the issuing bank when the LC is opened. Typically 0.5%–1% of the LC value per quarter, or a minimum flat fee. On a £100,000 LC, this might be £500–£1,000 for a 90-day LC.
Advising fee (seller’s cost)
Charged by the advising bank for receiving and authenticating the LC. Usually a flat fee: £100–£200 in most UK banks.
Confirmation fee (seller’s cost)
If the LC is confirmed, the confirming bank charges an additional fee, typically 0.5%–2% per annum of the LC value, depending on the country risk of the issuing bank. On a £100,000 LC, confirmation might cost £500–£2,000.
Document examination fee (seller’s cost)
Charged when documents are presented for checking. A flat fee per presentation: £150–£300 typically.
Amendment fee
If the LC needs to be changed after it is issued: for example, to extend the shipment deadline, both the issuing bank and the advising bank may charge amendment fees. Budget £100–£200 per bank per amendment.
Discrepancy fee
If a discrepancy is found, banks charge a discrepancy fee before processing the waiver. Around £75–£150 per discrepancy.
Reimbursement/negotiation fee
The advising bank may charge for negotiating or forwarding the document set. Varies by bank and transaction.
Total cost on a £100,000 LC: typically £1,500–£4,000, depending on LC type, confirmation, country of import, and whether amendments or discrepancies arise. For smaller LCs, the fixed fees make the effective cost percentage higher.
Payment is guaranteed by a bank, not just a buyer. The biggest risk in export trade is that the buyer does not pay. An LC removes that risk, as long as the seller presents complying documents, the bank must pay. The seller does not need to rely on the buyer’s goodwill or ability to pay.
Payment is independent of the buyer’s financial health. If the buyer’s business runs into trouble after the LC is issued, it does not matter. The bank’s obligation to pay is separate from the buyer-seller relationship. This is one of the core principles of LC law.
Enables trade with unknown buyers. Without an LC, exporting to a new buyer in an unfamiliar market is a leap of faith. With an LC from a reputable bank, the seller has a bankable guarantee. This opens up markets that would otherwise be too risky on open account terms.
Financing opportunities. A confirmed LC can be used as security to get pre-shipment finance. Some banks will lend against an LC to help the seller fund production.
Structured process reduces disputes. Because the LC defines exactly what documents are needed, both sides know what is expected. There is less room for misunderstandings after the fact.
The bank only pays when documents prove shipment has happened. The buyer does not pay until documents confirming the goods have been shipped are presented. This is majorly safer than paying a supplier in advance and hoping the goods arrive.
Document control. The LC specifies which documents are required. The buyer can insist on an inspection certificate, a certificate of origin, or specific insurance cover. If the seller cannot produce them, no payment is triggered.
Leverage to enforce contract terms. The LC terms reflect the sales contract. If the seller ships late, ships the wrong goods, or uses the wrong port, the documents will not comply and the bank will not pay.
Payment terms can be extended. A usance LC (deferred payment) gives the buyer time to receive the goods, sell them, and generate cash before the payment date arrives. This improves cash flow for the importer.
Creditworthiness extended to the transaction. If the buyer is relatively unknown in the seller’s market, the issuing bank’s credit substitutes for the buyer’s. A small UK importer backed by a Barclays or HSBC LC is far more credible to an overseas supplier than the same importer offering open account.
Cost. Bank fees for an LC can add 1.5%–4% to the cost of a transaction. For high-margin goods, this is manageable. For low-margin commodities, it can make the deal uneconomic.
Administrative burden. Preparing a full set of LC-compliant documents is time-consuming. The seller needs experienced staff or a knowledgeable freight forwarder to get it right. One mistake creates a discrepancy and delays payment.
Strict compliance is unforgiving. A single typo can create a discrepancy. The seller must spend time checking and double-checking every document before presentation. The 70% first-presentation discrepancy rate shows how difficult this is in practice.
Slow process. From the moment the buyer applies for the LC to the moment the seller receives payment, several weeks can pass. If amendments are needed, or discrepancies arise, the timeline extends further. This is not a fast payment mechanism.
Fraud risk (for buyers). A letter of credit guarantees payment against documents. It does not guarantee the goods are what they are supposed to be. A fraudulent seller can present perfectly compliant documents for a container of worthless goods. The buyer’s recourse is a legal dispute, not an LC dispute.
Currency and country risk (if unconfirmed). If the issuing bank is in a country with currency controls or political instability, there is a risk the bank cannot or will not honour the LC. Confirmation by a UK bank removes this risk but adds cost.
Ties up buyer’s credit line. Issuing an LC consumes the buyer’s trade finance facility with their bank. A buyer with a limited facility cannot open multiple large LCs simultaneously.
| Payment Method | Risk to Exporter | Risk to Importer | Cost | Speed | When Used |
|---|---|---|---|---|---|
| Open Account | High — seller ships goods and waits to be paid. Buyer could default. | Low — buyer pays after receiving and checking goods. | Lowest — no bank fees. | Fast. | Between established, trusted trading partners. Common in intra-EU and domestic trade. |
| Documentary Collection (D/P or D/A) | Medium — bank controls document release, but there is no bank payment guarantee. Buyer could refuse documents. | Medium — buyer inspects documents before paying, but has less control than open account. | Low — modest bank handling fees. | Moderate. | When there is some trust but the seller wants document control. Lower cost alternative to an LC. |
| Letter of Credit (LC) | Low — bank guarantees payment against complying documents. | Medium-low — buyer controls LC terms, but must fund the bank. | Higher — issuing, advising, confirmation, and examination fees. | Slower — document preparation and bank checking take time. | High-value or high-risk transactions. New buyer relationships. Emerging market trade. |
| Payment in Advance | Lowest — seller receives money before shipping. | Highest — buyer has paid before seeing goods. Risk of non-delivery. | Low-moderate — transfer fees only. | Fast. | When the seller has all the power (e.g., rare goods, strong market position). |
The key insight from this table: as risk to the exporter decreases, cost and complexity increase. An LC is not always the right tool, but when the risk warrants it, nothing offers better protection at a reasonable cost.
An LC is the right choice in specific circumstances. It is not right for every trade.
Use an LC when:
Do not use an LC when:
The scenario: A UK manufacturer based in Birmingham. Midlands Precision Parts Ltd, wins an order to supply precision-engineered components to a buyer in Indonesia. The contract value is £85,000. The buyer is new. Midlands Precision has never traded with them before. The buyer’s country carries some payment risk. The buyer’s bank is a regional Indonesian bank that Midlands Precision’s finance team has never heard of.
What they do: Midlands Precision insists on a confirmed, irrevocable, sight LC. They will not ship until they have a confirmed LC in their hands, reviewed and approved.
The LC is opened: The Indonesian buyer applies to their bank (the issuing bank) for an LC in favour of Midlands Precision Parts Ltd, Birmingham, UK. The issuing bank issues the LC and sends it via SWIFT to HSBC UK (the advising bank, chosen because it is Midlands Precision’s trade bank). HSBC adds its confirmation.
The LC terms require:
Midlands Precision ships the goods from their Birmingham warehouse, delivered to Felixstowe for a vessel departing 10 August. B/L date: 10 August.
They prepare the documents carefully, using the exact goods description from the LC. Their freight forwarder helps. They get the certificate of origin from Birmingham Chamber of Commerce. They arrange marine cargo insurance through their broker.
A near miss: The draft invoice describes the goods as “precision steel components.” Midlands Precision’s export manager catches it before submission, the LC says “precision-engineered steel components.” She corrects the invoice. That one correction probably saved a discrepancy notice.
Documents presented: 21 August, within the 21-day window and before the LC expiry date. HSBC examines the documents. No discrepancies found. HSBC pays Midlands Precision the £85,000 on 24 August (three banking days for examination).
The costs incurred:
Midlands Precision absorbs the confirmation and examination fees (£2,050) as a cost of doing business. The buyer pays the issuance fee in Indonesia. The net cost to Midlands Precision is around 2.4% of the transaction value, a reasonable price for a bank-guaranteed payment from a first-time buyer in a higher-risk market.
What is the difference between a sight LC and a usance LC?
A sight LC pays the seller as soon as complying documents are presented and checked, typically within five banking days. A usance (or term) LC sets a deferred payment date, such as 60 or 90 days after the bill of lading date. The buyer gets time to sell the goods before paying. The seller waits longer for their money, though they may be able to discount the usance LC with their bank to get cash earlier.
What does “confirmed” mean and do I need it?
Confirmation means a second bank, usually in the seller’s country, adds its own payment guarantee to the LC. If the issuing bank fails to pay, the confirming bank pays instead. You need confirmation if you are worried about the creditworthiness of the issuing bank or the country risk of the buyer’s country. If the issuing bank is a well-known international bank in a stable country, confirmation may not be necessary.
Can an LC be cancelled once it is issued?
Not without the agreement of all parties. Under UCP 600, all LCs are irrevocable by default. This means neither the buyer nor the issuing bank can cancel the LC unilaterally after it has been issued. Any change requires the agreement of the beneficiary (the seller) as well.
What happens if the goods arrive before the documents?
This can happen on short-distance shipments. The buyer may want to release the goods before the original bill of lading arrives. In that case, the shipping line can release goods against a letter of indemnity (LOI), but this carries risk, as it bypasses normal LC document control. Some importers arrange a telex release or express bill of lading for short-voyage routes to avoid this problem entirely.
Can I get an LC for a small shipment?
Technically yes, but it may not be cost-effective. If your shipment is worth £5,000 and the bank fees alone come to £400–£600, you are paying 8%–12% of the transaction value in fees. For small transactions, documentary collection or trade credit insurance may be more appropriate tools.
What is UCP 600 and does it apply in the UK?
UCP 600 is the ICC’s set of rules governing letters of credit. It was last updated in 2007. It applies whenever an LC states that it is issued subject to UCP 600, which is standard practice worldwide, including in the UK. Post-Brexit, UK banks continue to operate under UCP 600. There is no UK-specific equivalent; ICC rules are international by design.
What is a standby letter of credit?
A standby LC works differently from a commercial LC. A commercial LC is the primary payment mechanism, payment happens through the LC. A standby LC is a fallback: payment is only triggered if the applicant fails to pay or perform. It functions more like a bank guarantee or performance bond. Standby LCs are common in the US market and in service contracts. They are governed by either UCP 600 or ISP98 (International Standby Practices).
How long does an LC take from application to payment?
A straightforward LC might take 2–3 weeks from application to payment, a few days to issue, a few days to advise, then shipment and document preparation time, then five banking days for examination. If amendments are needed, or discrepancies arise, add another week or more per cycle. Build the LC lead time into your production and logistics planning from the start.
A letter of credit is a bank guarantee, the buyer’s bank promises to pay the seller, provided the seller presents complying documents.
Letters of credit are governed by ICC UCP 600. UK banks use UCP 600, and this has not changed post-Brexit.
There are five parties in most LC transactions: applicant (buyer), beneficiary (seller), issuing bank, advising bank, and (optionally) confirming bank.
The two most common types are sight LCs (pay on document presentation) and usance LCs (pay at a future date).
The strict compliance rule means documents must match the LC terms exactly. Even a minor typo creates a discrepancy.
Around 70% of first document presentations have at least one discrepancy. Always read the LC carefully before shipping and check every word of your documents before presentation.
Total bank charges on a £100,000 LC typically run to £1,500–£4,000, depending on LC type and complexity.
Confirmation adds cost but gives the seller a payment guarantee from a bank they know and trust, important when the issuing bank is in a risky country.
Letters of credit offer strong payment security for exporters in exchange for higher cost and administrative complexity. They are best suited to high-value transactions with new or higher-risk buyers.
For regular, trusted trading relationships, open account or documentary collection are usually more cost-effective. The LC is the right tool when the risk genuinely warrants it.
This article is part of a learning path — return to explore more topics.
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