Letter of credit basics start with one idea: a bank promises to pay the seller if the seller shows the right papers. The buyer asks its bank to issue the promise. The seller then trusts the bank, not the buyer. This is why a letter of credit is common when two firms in different countries have never traded before. The ICC rules call it a documentary credit. The two names mean the same thing.
Who is in the deal
Every letter of credit has the same cast. The buyer is called the applicant. The buyer asks its bank to issue the credit. That bank is the issuing bank. The seller is the beneficiary. The credit is issued in the seller's favour.
Two more banks often appear. An advising bank tells the seller that the credit exists and checks that it looks real. A confirming bank adds its own promise on top of the issuing bank's promise. That helps a seller who is unsure about the buyer's bank or the buyer's country.
The credit stands apart from the sales contract. If the two disagree, the bank follows the credit. The bank does not read your sales contract.
Sources: ICC, UCP 600 (2007 revision), Article 2 and Article 4.
How the payment flows
The steps are short and always in the same order.
First, buyer and seller agree on the sale and say that payment will be by letter of credit. Second, the buyer asks its bank to issue the credit. Third, the bank sends it to the seller, often through an advising bank. Fourth, the seller ships the goods and collects the papers, such as the invoice and the transport document. Fifth, the seller hands the papers to the bank. Sixth, the bank checks them. If they match the credit, the bank pays, or promises to pay on a set date.
The rule book for most credits is UCP 600, issued by the International Chamber of Commerce (ICC) in its 2007 revision. Under UCP 600, a credit is irrevocable even if it does not say so. Once issued, it cannot be changed or cancelled unless the issuing bank, any confirming bank and the seller all agree.
Sources: ICC, UCP 600 (2007 revision), Articles 3 and 10.
Banks check papers, not goods
This is the point that surprises new exporters. Under Article 5 of UCP 600, banks deal with documents. They do not inspect the goods, the services or the work the papers describe.
So a perfect shipment can still go unpaid if the papers are wrong. A box count that differs from the invoice, a name spelled two ways, or a date that falls outside the credit can all be called a discrepancy. A bank has up to five banking days after the day of presentation to decide whether the papers comply (Article 14).
The same rule protects you. If your papers match the credit word for word, the bank must honour them, even if the buyer later complains about the goods.
Sources: ICC, UCP 600 (2007 revision), Articles 5 and 14.
Dates and deadlines to watch
Two dates matter most. Every credit must state an expiry date, and you must present your papers on or before it. Also, for credits that call for a transport document, the papers must reach the bank within 21 calendar days after shipment, and never later than the expiry date, unless the credit says otherwise.
A practical habit helps here. When the credit arrives, read every line the same day. Compare it with your sales contract. If the price, the port, the goods description or the dates differ, ask the buyer to amend the credit before you ship. An amendment after shipment is slow, and the clock is already running.
Sources: ICC, UCP 600 (2007 revision), Articles 6 and 14.
When a small exporter should ask for one
A letter of credit costs money in bank fees, and it takes care and time. It is not for every sale. It earns its place in a few cases.
Ask for one when the buyer is new to you and you have no payment record. Ask when the order is large compared with your cash. Ask when the buyer is in a market where moving money out is slow or uncertain. In those cases, a bank's promise is worth more than a buyer's word.
Skip it, or keep it simple, when you have traded for years with the same buyer and they always pay on time. A plain invoice on agreed terms is faster and cheaper.
If you do use one, ask your own bank to check the credit before you ship. Ask whether your bank offers this check. If the buyer's bank is weak or the country risk is high, ask about a confirming bank. You will pay for the extra promise, so weigh the cost against the size of the order.
This is general information only. For fees and for how the rules apply to your own trade, ask your bank or a trade finance lawyer.
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