Letters of Credit: Securing International Payments When Trust Is Low

International trade involves a fundamental trust problem: the buyer doesn't want to pay until they receive the goods, and the seller doesn't want to ship until they've been paid. Letters of credit solve this by putting a bank in the middle to guarantee payment.

What Is a Letter of Credit?

A letter of credit (LC) is a financial instrument issued by a bank (the issuing bank) on behalf of the buyer (applicant), guaranteeing payment to the seller (beneficiary) provided specific documentary conditions are met.

In simple terms: the bank promises to pay the seller when the seller proves they've shipped the correct goods by presenting the required documents.

How the LC Process Works

1. Buyer and seller agree on trade terms, including LC as the payment method
2. Buyer applies to their bank to issue an LC
3. Issuing bank sends the LC to the advising bank in the seller's country
4. Seller ships the goods and obtains the required documents (bill of lading, commercial invoice, packing list, certificate of origin, insurance certificate, etc.)
5. Seller presents documents to the advising bank
6. Banks examine documents for compliance with the LC terms
7. Payment is made to the seller if documents comply
8. Buyer's bank debits the buyer and releases documents for customs clearance

Types of Letters of Credit

Irrevocable LC

The most common type. Cannot be cancelled or modified without agreement from all parties. Provides the strongest security for the seller.

Confirmed LC

A second bank (the confirming bank, usually in the seller's country) adds its guarantee to the issuing bank's commitment. This is important when the issuing bank is in a country with political or economic instability.

Sight LC

Payment is made immediately upon presentation of compliant documents. The seller receives payment as soon as the bank verifies the paperwork.

Usance (Time) LC

Payment is made after a specified period (30, 60, 90 days) from the document presentation date. This gives the buyer time to sell the goods before paying.

Revolving LC

Automatically renews for multiple shipments within a specified period. Useful for ongoing trade relationships with regular shipments.

Standby LC

Functions as a guarantee rather than a payment mechanism. The seller draws on it only if the buyer fails to pay through other agreed methods.

When to Use Letters of Credit

Use an LC when:

• Trading with a new supplier where trust hasn't been established
• Large order values where the financial risk is significant
• Trading with countries where the legal system makes dispute resolution difficult
• The supplier requires it — many manufacturers won't ship high-value orders without LC payment
• Your bank requires it — some trade finance facilities mandate LC use

Consider alternatives when:

• Established relationships — Open account terms (30/60/90 days) are simpler and cheaper
• Small orders — LC costs may be disproportionate to the order value
• Time pressure — LC processing takes 1-3 weeks; wire transfers are faster
• Domestic transactions — LCs are designed for international trade risk

Costs of Letters of Credit

LC costs are shared between buyer and seller, though allocation varies by negotiation:

Buyer's costs:

• Issuance fee — 0.5-3% of the LC value (annual rate, pro-rated to the LC period)
• Amendment fees — $50-200 per amendment
• Margin/deposit — Some banks require a percentage of the LC value held as security

Seller's costs:

• Advising fee — $50-200
• Confirmation fee — 0.5-2% if a confirmed LC is requested
• Document examination fee — $50-150 per presentation

Common extra charges:

• Discrepancy fees — $50-100 per discrepancy in documents
• SWIFT message fees — $30-80 per message
• Courier fees — For sending original documents

Common LC Problems and How to Avoid Them

Document Discrepancies

Statistics suggest 60-70% of first document presentations contain discrepancies. Even minor errors — a misspelled company name, incorrect port name, missing document — can cause rejection.

Prevention: Create a detailed checklist of required documents and review each one carefully before presentation. Ensure your supplier understands the exact requirements.

LC Amendments

Changes to shipping dates, quantities, product descriptions, or other terms require formal amendments, each costing time and money.

Prevention: Finalise all details before the LC is issued. Don't apply for the LC until the purchase order is completely confirmed.

Timing Issues

LCs have validity periods. If shipping is delayed beyond the LC expiry, the payment guarantee disappears.

Prevention: Build buffer time into the LC validity period. If your supplier says goods will ship in 30 days, set the LC expiry for 45-60 days.

Practical Advice for Importers

• Start with your bank. Discuss trade finance options with your business banker before you need them. Understanding available facilities and their costs helps you negotiate better terms with suppliers.
• Factor LC costs into your landed cost. These are real transaction costs that affect your per-unit profitability.
• Graduate to open account. As you build trust with a supplier over multiple successful transactions, negotiate a move from LC to open account terms. This reduces costs and complexity for both parties.
• Keep copies of everything. LC documents are legally binding. Maintain complete files for each transaction.