Letter of Credit: How It Works for Exporters and Importers

A letter of credit is a bank's written promise to pay a seller once the seller presents specific documents that match the letter's terms. The buyer's bank issues it, and the seller can rely on the issuing bank's credit standing instead of the buyer's. That is the core of the letter of credit meaning: payment depends on documents, not on the buyer's goodwill. The most common form is the documentary letter of credit, which ties payment to shipping and customs paperwork.

The arrangement suits trade between parties who do not know each other well, or where the buyer and seller operate under different legal systems. The bank sits in the middle and checks that the paperwork matches the instructions before any money moves.

Who does what in a letter of credit

Each role carries a distinct obligation, and confusing them is a frequent source of disputes.

• Applicant — the buyer (importer). Opens the credit through its bank and agrees to reimburse it.
• Issuing bank — the buyer's bank. It issues the credit and undertakes to pay a complying presentation.
• Beneficiary — the seller (exporter). Presents documents to claim payment.
• Advising bank — usually a bank in the seller's country. It authenticates the credit and passes it to the beneficiary but does not guarantee payment unless it also confirms.
• Confirming bank — adds its own payment undertaking, so the seller gets paid even if the issuing bank fails.

Most letters of credit follow the ICC's Uniform Customs and Practice for Documentary Credits (UCP 600). Confirm the applicable version and any amendments on the issuing bank's documents before you sign anything. Rules on enforcement and local practice differ by country, so verify requirements with your own bank.

How a letter of credit works, step by step

The process runs in a fixed order. Skipping a step is what usually causes payment problems later.

1. Contract first. The sales contract names the payment method, the documents required, and who bears charges and freight.
2. Application. The buyer applies to its bank, giving the beneficiary's exact name, amount, currency, expiry date and the document list.
3. Issuance and advice. The issuing bank issues the credit and sends it to the advising bank, which passes it to the seller.
4. Review. The seller checks every field against the contract. Amount, description, dates and document names must match.
5. Shipment. The seller ships within the stated period and collects the required documents.
6. Presentation. The seller presents documents to the advising, confirming or nominated bank inside the presentation period, typically 21 days after shipment unless the credit says otherwise.
7. Examination. The bank checks the documents against the credit. If they comply, it pays or accepts a draft for later payment.
8. Reimbursement. The issuing bank pays the nominated bank and debits the buyer, who receives the shipping documents and collects the goods.

Documents a credit usually calls for

The exact list depends on the goods and destination. Agricultural shipments, for example, often add phytosanitary certificates, while dangerous goods add transport declarations.

Types of letter of credit you will meet

The variants below change who carries which risk, not the basic document-driven logic.

Irrevocable and confirmed

Under UCP 600, a credit is irrevocable by default, so the issuing bank cannot change it without the beneficiary's consent. A confirmed credit adds a second bank's promise to pay. Sellers in higher-risk markets usually ask for confirmation; the advising bank charges a fee for it, and the sales contract should say who pays.

At sight versus usance

A sight credit pays when documents comply. A usance, or deferred payment, credit pays a set number of days after shipment or after presentation. Usance gives the buyer time to sell the goods first, but the seller waits for cash unless it discounts the receivable.

Transferable, back-to-back and standby

A transferable credit lets a middleman pass part of the credit to its own supplier. A back-to-back credit is a separate credit opened against the security of the first. A standby letter of credit works more like a guarantee: it pays only if the applicant fails to perform. Issuers may apply different rule sets to standbys, so check which rules the document cites.

What the seller must get right before shipping

Banks pay against documents, not against goods. A perfectly shipped cargo can still go unpaid if the paperwork does not match the credit word for word. Most rejections trace back to the same handful of causes, and each is avoidable.

Common causes of rejection

• Late presentation past the credit's expiry or the stated presentation period
• Invoice description that does not match the credit exactly
• Dates out of sequence, such as an insurance date after the shipment date
• Partial shipment or transshipment when the credit does not allow it
• Missing signatures, endorsements or document copies
• Amounts drawn above the credit value or in the wrong currency

Ask your bank to pre-check a draft set of documents before you ship. Many discrepancies are visible on a first read and cost nothing to fix at that stage.

Costs and timing to plan for

Fees vary by bank, country and credit size. Expect charges for issuance, advising, confirmation, amendments and document examination, plus a margin or cash cover the issuing bank may require from the buyer. Confirm in the contract which side pays which fee. Timing also varies: advising can take a day or several, and examination periods depend on the bank. Build these into your shipment schedule rather than assuming same-day service.

A short illustrative example

Suppose a US furniture maker sells to a buyer in another country under a confirmed sight credit for goods shipped from a US port. The credit requires a commercial invoice, a full set of bills of lading, a packing list and a certificate of origin. The seller ships within the stated window and presents documents six days later, inside the presentation period.

The shipping line has marked the bill of lading with a different consignee name than the credit states. The advising bank flags the discrepancy and asks the issuing bank whether the buyer will accept it. The buyer agrees, the bank pays, and the shipment clears. Had the buyer refused, the seller would have held goods abroad with no payment guarantee. Pre-checking the bill of lading against the credit would have caught the mismatch before shipment.

All figures and timelines above are illustrative only; your credit terms control.

Practical takeaway for exporters and importers

Treat the letter of credit as a document contract. For exporters, read the credit line by line before shipping, confirm the presentation period and expiry, and decide whether confirmation is worth the fee. For importers, keep the credit terms precise but realistic, because an over-detailed document list raises the chance of rejection and delays your goods. Both sides should name the applicable rules, allocate fees in the contract, and check current requirements with their banks, since practice and regulation differ by jurisdiction.

This article is general information, not financial, legal or tax advice.