What is a letter of credit?
LC · Letter of Credit
A bank undertaking to pay the seller once compliant documents are presented. It substitutes the bank’s credit for the buyer’s, which is why it remains the default instrument between counterparties trading together for the first time.
Key points
- Banks deal in documents, not goods.
- Compliant documents must be paid even if the cargo is defective.
- Confirmation removes issuing-bank and country risk, at a cost.
At a glance
| What it is | A bank undertaking to pay against compliant documents |
|---|---|
| Governing rules | UCP 600 |
| Protects against | Buyer credit risk |
| Does not protect against | Quality — require inspection certificates instead |
| Confirmed | A second bank adds its own undertaking, usually in the seller's country |
The basic undertaking
A letter of credit — more precisely a documentary credit — is an undertaking by a bank to pay the seller when the seller presents documents that comply with the credit’s terms. It substitutes the bank’s creditworthiness for the buyer’s.
That is why it remains the default instrument between parties trading for the first time, and in trades where the buyer’s balance sheet is unknown to the seller. Most credits are issued subject to UCP 600, the ICC rules governing documentary credits.
Documents, not goods
The governing principle is that banks deal in documents, not in goods. If the presented documents comply on their face, the bank must pay, even if the cargo turns out to be defective. If they do not comply, the bank may refuse, even if the cargo is perfect.
This cuts both ways. It gives the seller certainty of payment against a document set it controls, and it gives the buyer no protection at all against quality — which is why independent inspection and a certificate of analysis belong among the required documents.
Discrepancies, confirmation and cost
A large proportion of first presentations are rejected for discrepancies — a date out of range, an inconsistent description, a missing endorsement. Discrepant documents can usually be corrected or accepted with the buyer’s waiver, but each cycle costs time and sometimes leverage.
A confirmed credit adds a second bank’s undertaking, normally in the seller’s country, which removes issuing-bank and country risk. It costs more, and is worth it whenever the issuing bank or its jurisdiction is one the seller would not otherwise take exposure to.
Frequently asked questions
- What is the difference between a confirmed and unconfirmed LC?
- A confirmed credit carries a second bank’s independent undertaking to pay, usually in the seller’s country, removing issuing-bank and country risk. An unconfirmed credit relies on the issuing bank alone.
- What happens if documents are discrepant?
- The bank may refuse to pay. In practice discrepancies are often corrected and re-presented, or accepted under a buyer’s waiver, but the seller loses time and some negotiating position.
- Does a letter of credit protect against poor quality?
- No. Banks deal in documents, not goods. Quality protection comes from requiring inspection certificates within the document set, not from the credit itself.
Related terms
The document issued by the carrier that serves as receipt for the cargo, evidence of the contract of carriage, and — critically — a document of title. Whoever holds the original endorsed bill controls the goods.
As CFR, but the seller also buys marine insurance for the voyage. Risk still transfers on loading at origin; the buyer simply has a policy to claim against. Standard minimum cover is Institute Cargo Clauses (C) unless the contract says otherwise.
Know Your Customer and Know Your Business: verification of identity, ownership and sanctions status of a counterparty before contracting. A cargo can be frozen mid-voyage over a party that should never have entered the chain.
An initial payment, commonly 80–90% of estimated value, released against shipping documents, with the balance settled once final weights and assays are agreed at discharge. Standard practice for concentrates.
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