Letter Of CreditEdit

A letter of credit (LC) is a payment mechanism used in international trade that relies on the creditworthiness of a bank rather than the buyer’s cash flow alone. In practice, an LC is a written commitment by a bank (the issuing bank) on behalf of a buyer (the applicant) to pay a seller (the beneficiary) a stated amount, provided the seller presents documents that conform to the terms and conditions of the instrument. By shifting performance risk from the seller to the banking system, LCs create a reliable framework for cross-border commerce, especially where buyers and sellers may have little prior experience with one another. In this way, LCs strengthen trust in contractual performance while preserving the freedom of private firms to engage in voluntary trade under a common set of rules. International trade Banks and firms rely on LCs to reduce the friction that can arise when dealing across borders, currencies, and legal systems.

The instrument sits at the intersection of private contract, banking practice, and international law. It is underpinned by clearly defined documents, standardized rules, and the ability of banks to assess and manage risk. Because the bank’s obligation is conditional on documentary compliance rather than merely on the financial strength of the buyer, LCs are a practical tool for enforcing performance in markets where legal enforcement may be uncertain or uneven. This has made LCs a cornerstone of Trade finance in a global economy that prizes specialization and scalable risk management. ICC UCP 600

History

The modern letter of credit grew out of centuries of mercantile practice and the need to formalize payment when buyers and sellers were separated by distance, language, and law. By the late 19th and early 20th centuries, banks began offering standardized LC services to facilitate shipping and payment in international transactions. Over time, private sector practice standardized around widely accepted rules maintained by the International Chamber of Commerce. The core framework, known as the Uniform Customs and Practice for Documentary Credits, evolved into versions such as UCP 600, which governs the behavior of banks and the handling of documentary requirements. These rules help ensure predictability, reduce disputes, and accelerate settlement in cross-border deals. The growth of global trade and the expansion of banking services have kept the LC central to the finance of international commerce. Uniform Customs and Practice for Documentary Credits ICC International trade

How a letter of credit works

A buyer and seller agree to a transaction and specify an LC as the payment method. The buyer applies to their bank for an LC, naming the seller and the shipment terms. The bank may require collateral or an adjustment in terms to reflect risk. Banks provide a formal commitment to pay if the seller documents comply with the LC’s terms. Banking
The issuing bank issues the LC and forwards the documentary requirements to the seller’s bank (the advising or confirming bank). The LC stipulates what documents must be presented (for example, a commercial invoice, a bill of lading, an insurance document, and certificates of origin). The documents are then reviewed for conformity with the LC. Bill of lading Commercial invoice Insurance certificate Certificate of origin
The seller ships the goods and presents the required documents to their bank or the advising bank. If the documents conform, the bank negotiates payment or accepts a draft in exchange for the documents. The bank steps in to pay the seller, and funds are transferred to the seller’s account. The payment is then routed back to the issuing bank, which ultimately debits the buyer’s account. Negotiation Payment Documentary credits
Any discrepancy between the documents and the LC terms can trigger a payment refusal or a request for cure, which may delay settlement. This emphasis on documentary compliance is a key feature of LC risk management. Documentary credit Discrepancies in documentary credits

Types of letters of credit

Irrevocable vs revocable: Most contemporary LCs are irrevocable, meaning the issuer cannot change or cancel the terms without the consent of all parties. This provides stronger protection for the beneficiary. Irrevocable letter of credit Revocable letter of credit
Confirmed vs unconfirmed: A confirmed LC adds the obligation of a second bank (often in the seller’s country) to pay if the issuing bank fails to do so. This reduces country risk and strengthens seller confidence. Confirmed letter of credit
Standby letters of credit: A standby LC is a guarantee of payment used primarily to secure contractual obligations (such as performance or payment guarantees) rather than for routine shipment payments. Standby letter of credit
Transferable, back-to-back, revolving: These specialized forms accommodate particular trading arrangements, such as when multiple suppliers are involved or when contract terms require ongoing financing. Transferable letter of credit Back-to-back LC Revolving letter of credit

Parties and documents

The applicant (buyer) and the beneficiary (seller) are the primary contract principals. The issuing bank provides the payment obligation, while the advising or confirming bank communicates and authenticates the LC and, if applicable, provides the bank’s confirmation. The documents presented by the seller are the evidence of performance, often including a Bill of lading, a commercial invoice, an insurance document, and certificates of origin. Applicant Beneficiary Advising bank Confirming bank

Risk management and economics

The LC framework shifts counterparty credit risk from the seller to the banking system, anchored in the strength and reliability of the issuing bank and, where present, any confirming bank. The risk transfer is especially valuable when buyers and sellers operate in jurisdictions with uncertain legal frameworks or volatile currencies. Credit risk Currency risk Legal framework
Costs: LCs entail fees at several stages—issuance, confirmation (if elected), amendment, negotiation, and advising. While these costs can be material, they are weighed against the value of secure payment and timely settlement, particularly for exporters facing liquidity constraints or long receivables cycles. Open accounting and other methods have different risk and cost profiles, and firms choose the instrument that best aligns with their risk appetite and competitive strategy. Trade finance Open account
Regulation and standards: The effectiveness of LCs depends on adherence to international rules and banking standards. The ICC’s rules (UCP 600) and related guidance help keep practices predictable across borders and currencies. Basel III and other banking regulations also shape how banks price and underwrite LC risk. Basel III UCP 600

Controversies and debates

Cost and complexity versus security: Critics argue that LCs add layers of cost and administrative burden, which can be especially onerous for small or new market entrants. Proponents contend that the added cost is offset by the greater certainty of payment and the ability to access supply chains that rely on reliable performance. The debate often centers on whether alternative methods (such as open account terms or escrow arrangements) better fit a given transaction or market condition. Open account Escrow
Impact on small businesses: Some observers worry that the structure and documentation requirements of LCs favor larger exporters with in-house compliance capacity. In response, the banking sector and industry groups advocate standardized documentary templates and streamlined processes to broaden access while preserving risk controls. Trade finance Small business
Fraud and documentary risk: A perennial concern is the possibility of presenting nonconforming or fraudulent documents. Banks mitigate this through strict documentary checks, clear LC terms, and, in some cases, confirmation by a second bank. The balance between speed of settlement and thorough examination remains a core tension in LC practice. Fraud in trade finance Documentary credits
Globalization and policy critiques: From a market-oriented perspective, LCs enable robust cross-border trade by providing credible payment assurances, which supports specialization and comparative advantage. Critics may argue that open-ended supply chains erode domestic industries or shift risk to the financial sector. Advocates counter that LCs are tools of private sector risk management rather than instruments of state policy, and they should be evaluated on their efficiency, reliability, and impact on economic growth. Trade policy Globalization
Woke criticisms and defenses: Some critique the global trade finance system as entrenching power dynamics or suppressing local alternatives. A practical defense emphasizes that LCs reduce default risk in uncertain markets, facilitate access to working capital, and support legitimate commerce when backed by credible banking standards. Critics who dismiss such concerns as a missed opportunity to reform the system often overlook the measurable economic benefits of predictable payment arrangements and the role of private finance in enabling voluntary exchange. In this view, concerns about bias or inequity should be addressed through competitive improvements and prudent regulation, not by dismantling a tool that underpins modern commerce. Trade finance International law