What Is a Letter of Credit and How It Works in Export-Import

When conducting business internationally, one of the biggest challenges both exporters and importers face is payment security. How can a seller be sure they will get paid after shipping goods? How can a buyer be confident that payment is only made after the seller fulfills their part of the deal?

This is where the Letter of Credit (LC) becomes a vital tool in export-import transactions.

What Is a Letter of Credit?

A Letter of Credit is a written commitment from a bank (usually the buyer’s bank) guaranteeing payment to the exporter, provided the exporter meets specific terms and conditions stated in the LC. Essentially, it shifts the payment risk from the buyer to the bank.

This financial instrument reassures exporters that they will receive payment if they present the required documents proving that goods have been shipped according to the contract. On the other hand, importers gain assurance that payment will only be made once the exporter meets all obligations.

Types of Letters of Credit Commonly Used in Trade

There are several types of LCs, but the most common include:

• Revocable LC: Can be changed or canceled by the buyer or issuing bank without the exporter’s consent. Less secure for exporters.
• Irrevocable LC: Cannot be changed or canceled without agreement from all parties, offering greater security.
• Confirmed LC: A second bank (usually in the exporter’s country) adds its guarantee to pay if the issuing bank fails to do so.
• Sight LC: Payment is made immediately upon presentation and verification of required documents.
• Usance (or Deferred Payment) LC: Payment is made after a specified period, allowing the importer time to sell the goods or arrange funds.

How Does a Letter of Credit Work?

The LC process involves multiple parties and clear steps:

1. Sales Contract: The buyer and seller agree on the sale terms, including the use of an LC for payment.
2. Opening the LC: The buyer requests their bank to issue an LC in favor of the seller.
3. Notification: The issuing bank sends the LC to the exporter’s bank (advising bank), which informs the exporter.
4. Shipment of Goods: The exporter ships the goods and collects all required documents (bill of lading, invoice, packing list, certificate of origin, etc.).
5. Presentation of Documents: The exporter submits the documents to their bank to verify compliance with LC terms.
6. Payment: Once documents are verified, the issuing bank pays the exporter either immediately or at a deferred time, depending on the LC type.
7. Reimbursement: The importer reimburses their bank as agreed.

Why Is a Letter of Credit Important in Export-Import?

• Reduces payment risk: Exporters are protected against buyer default or insolvency.
• Builds trust: Assures both parties that payment and delivery conditions are met.
• Facilitates financing: Exporters can often use the LC as collateral for loans or advances.
• Supports regulatory compliance: Ensures documents meet international trade and customs requirements.

Tips for Using Letters of Credit Effectively

• Understand the terms carefully: Every detail matters—any discrepancy in documents can cause payment delays.
• Work with experienced banks: Choose banks familiar with international trade and the LC process.
• Keep good records: Accurate and timely document submission is key to smooth transactions.
• Plan for contingencies: Understand what happens if goods are delayed or terms cannot be met exactly.

Conclusion

A Letter of Credit is more than just a bank document—it’s a critical tool that provides security, trust, and efficiency in international trade. Both exporters and importers benefit by reducing risks and ensuring that goods and payments flow smoothly.

For businesses involved in export-import, mastering the use of Letters of Credit is essential for successful and sustainable global trading relationships.