What Is a Letter of Credit? How Businesses Use It to Secure Trade Finance

A letter of credit is a widely used financial instrument that facilitates secure and reliable transactions, particularly in trade finance. It serves as a formal commitment by a bank to pay a seller on behalf of a buyer, provided that the terms outlined in the agreement are fulfilled. 

This mechanism is especially valuable for middle market businesses and lower middle market companies that frequently engage in domestic or international trade. When dealing with unfamiliar partners or high-value contracts, the risk of non-payment or delivery issues can create significant financial strain. A letter of credit helps mitigate these risks by offering assurance to both parties, strengthening commercial relationships, and improving access to favorable payment terms. 

For companies managing tight cash flow or navigating complex supply chains, this financial tool can support continued growth while maintaining operational stability and protecting working capital.

What Is a Letter of Credit?

A letter of credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller, provided that specific terms and conditions are met. It is commonly used in trade finance to reduce payment risk between unfamiliar parties, especially in cross-border transactions. The buyer’s bank issues the letter of credit to the seller, assuring that payment will be made once the seller presents the required documents, such as shipping records, invoices, and inspection certificates.

Letters of credit are widely accepted across various industries due to their reliability and legal structure. According to the International Chamber of Commerce (ICC), letters of credit are used in approximately 11–15% of global trade transactions, representing over $2 trillion annually in trade value.

Types of Letters of Credit

Selecting the right type of letter of credit is essential for ensuring payment security and smooth transaction execution. Each type serves a specific purpose and offers different levels of protection. 

Below is a detailed explanation of the most common types of letter of credit that businesses should be familiar with.

Revocable vs. Irrevocable Letters of Credit

A revocable letter of credit can be modified or cancelled by the issuing bank at any time without prior notice to the seller. This type offers minimal protection for the seller, making it unsuitable for most commercial transactions. It is rarely used in modern trade finance due to the high level of uncertainty it creates.

An irrevocable letter of credit cannot be changed or cancelled unless all involved parties, including the buyer, seller, and issuing bank, agree in writing. It provides a strong assurance to the seller that payment will be made as long as the terms are fully met. Irrevocable letters of credit are the standard choice in international trade because they minimize the risk of unexpected changes.

Confirmed vs. Unconfirmed Letters of Credit

An unconfirmed letter of credit is only backed by the issuing bank, which assumes the full responsibility for payment. While this may be sufficient in some cases, sellers may hesitate if the issuing bank is located in a country with economic or political instability, or if the bank's creditworthiness is uncertain.

To add more protection, a confirmed letter of credit includes a second guarantee from a confirming bank, often located in the seller's country. This bank promises to pay the seller even if the issuing bank fails to do so. Confirmed letters of credit are commonly used when the seller wants added assurance due to the perceived risk of the buyer's bank.

Standby Letter of Credit (SBLC)

A standby letter of credit serves as a backup payment method rather than a primary one. It is designed to be used only if the buyer fails to fulfill a contractual obligation, such as payment or project completion. This type of LC acts as a financial guarantee rather than a payment mechanism.

Businesses often use standby letters of credit in construction projects, service contracts, or long-term supply agreements. It offers the seller confidence that compensation will be available in case the buyer defaults, making it a useful risk mitigation tool.

Transferable and Back-to-Back Letters of Credit

A transferable letter of credit allows the original beneficiary, usually a trading company or intermediary, to transfer part or all of the payment rights to one or more secondary beneficiaries. This is particularly useful in supply chain transactions where an intermediary does not supply goods directly but coordinates the delivery from another party.

A back-to-back letter of credit involves two separate but linked letters of credit. The first LC is issued in favor of the intermediary, who then requests a second LC from their bank for the benefit of the end supplier. This structure enables the intermediary to finance the purchase of goods without using their own funds while keeping supplier and buyer details confidential from each other.

These types of letter of credit offer businesses flexibility and security when managing complex transactions, dealing with unfamiliar partners, or entering new markets. Choosing the correct structure depends on the nature of the transaction, the reliability of the parties involved, and the level of financial risk that needs to be managed.

How Does a Letter of Credit Work in Trade Finance?

A letter of credit is a structured process that helps reduce payment risk in domestic and international trade. Here’s how it typically works:

1. Buyer and seller agree on a contract:
   The buyer and seller finalize a sales agreement, and the seller requests payment via a letter of credit to reduce the risk of non-payment.
2. Buyer applies for a letter of credit:
   The buyer contacts their bank (issuing bank) to request a letter of credit in favor of the seller. The bank evaluates the buyer’s creditworthiness before issuing the LC.
3. Issuing bank sends the LC to the advising bank:
   The issuing bank sends the letter of credit to the seller’s bank (called the advising or confirming bank), which then notifies the seller.
4. Seller ships goods and provides documents:
   Once the goods are shipped, the seller presents documents such as the bill of lading, invoice, and insurance certificate to the advising bank.
5. Advising bank verifies documents:
   If the documents comply with the LC terms, the advising bank forwards them to the issuing bank for final review.
6. Payment is released:
   Upon confirmation that all terms are met, the issuing bank releases payment to the seller. The buyer later reimburses the issuing bank.

This process provides financial security to both parties and ensures smoother transactions in trade finance.

Benefits of Using Letters of Credit

Letters of credit are widely used in trade finance because they offer strong protection and flexibility. Here are the key benefits for businesses:

1. Reduced Risk of Non-Payment: A letter of credit assures the seller that they will receive payment as long as they meet the agreed terms. This reduces the risk of default, especially when dealing with overseas buyers or unfamiliar clients.
2. Improved Trust Between Parties: Letters of credit help build trust in international transactions. Even if the buyer and seller have never worked together, both sides can move forward knowing the bank guarantees payment under the right conditions.
3. Better Access to Global Markets: Many exporters and importers use letters of credit to enter new markets. Buyers can confidently purchase from international suppliers, and sellers are more likely to accept orders when payment is guaranteed.
4. Stronger Cash Flow Control: For the seller, payment becomes more predictable. For the buyer, the use of a letter of credit may allow more time to arrange funding since the bank provides the guarantee.
5. Competitive Advantage: Businesses that offer letters of credit as a payment method can gain a competitive edge. It shows professionalism and financial strength, which can help secure larger or more frequent orders.

Understanding the Risks and Costs of Using a Letter of Credit

While letters of credit offer strong payment security, they also come with costs and administrative requirements that businesses should understand before using them.

1. Bank Fees and Charges
   Banks charge various fees for issuing, advising, confirming, and amending a letter of credit. These costs can vary based on the transaction size, complexity, and the banks involved. Both the buyer and seller may be responsible for different parts of these charges, so it's important to clarify fee responsibilities in advance.
2. Complex Documentation Requirements
   Letters of credit are highly document-driven. The seller must submit all required documents exactly as specified. Even small discrepancies can lead to delayed payment or rejection. Businesses often need to hire specialists or train staff to manage documentation properly.
3. Potential Delays
   Processing and verifying documents may take time, especially if the transaction involves multiple banks in different countries. Any mistakes or missing paperwork can cause delays in payment and delivery.
4. Impact on Credit Limits
   For buyers, a letter of credit is considered a contingent liability. It can reduce available credit with the issuing bank, which may limit access to other types of financing.
5. Legal and Country Risks
   Cross-border transactions may be affected by political or regulatory changes in either country. Even with a letter of credit in place, complications can arise if laws change or if one of the banks involved becomes subject to sanctions or operational issues.

How to Get a Letter of Credit for Safe and Secure Global Transactions

Obtaining a letter of credit involves coordination between the buyer, their bank, and the seller. Businesses can follow these steps to ensure the process is smooth and secure:

1. Finalize the Sales Agreement
   Before applying, the buyer and seller should agree on contract terms, including the use of a letter of credit as the payment method. The agreement should clearly define shipment timelines, required documents, and payment conditions.
2. Apply Through a Reputable Bank
   The buyer submits an application to their bank, known as the issuing bank. This application includes details such as the beneficiary’s name (the seller), the amount, currency, expiration date, and a list of required documents. The bank reviews the buyer’s credit and financial standing before approval.
3. Bank Issues and Sends the Letter of Credit
   Once approved, the issuing bank prepares the letter of credit and sends it to the seller through an advising bank. This advising bank verifies the authenticity of the LC and shares it with the seller.
4. Seller Prepares and Ships Goods
   After receiving the LC, the seller arranges the shipment and prepares all necessary documents as outlined in the letter of credit. These may include a bill of lading, invoice, packing list, insurance certificate, and inspection report.
5. Submit Documents for Payment
   The seller submits the complete and accurate documentation to the advising bank. The bank reviews them and forwards them to the issuing bank for final checks.
6. Receive Payment Upon Verification
   If all documents comply with the terms of the letter of credit, the issuing bank releases the payment to the advising bank, which then pays the seller.

This process protects both parties. Buyers are assured the goods will be shipped as agreed, while sellers have confidence that they will receive payment.

For middle market and lower middle market companies, navigating international trade finance can be complex. Epoch Financial helps simplify this process by offering customized financing solutions that work alongside letters of credit. From trade support to working capital facilities, we help businesses maintain cash flow and minimize risk while expanding into global markets.

Frequently Asked Questions

Which type of letter of credit is safest?

The safest type of letter of credit for sellers is an irrevocable confirmed letter of credit. It cannot be changed or cancelled without the agreement of all involved parties, and it includes a second guarantee from a confirming bank, typically in the seller’s country. This structure protects the seller even if the issuing bank or buyer fails to pay, offering the highest level of security in international trade.

What are the documents required for a letter of credit?

The specific documents required under a letter of credit depend on the agreement between the buyer and seller, but commonly include:

• Commercial invoice
• Bill of lading or airway bill
• Packing list
• Insurance certificate
• Certificate of origin
• Inspection certificate (if applicable)
• Any other document specified in the LC terms

It is essential that all documents exactly match the LC requirements to avoid delays or rejection of payment.

Who requires a letter of credit?

A letter of credit is typically required by:

• Exporters who want payment protection before shipping goods
• Importers who need to assure sellers of payment security
• Middle market companies expanding into new regions with unfamiliar trading partners
• Lenders or trade finance providers who want documented control over the transaction

It is especially useful in cross-border trade where the buyer and seller have limited commercial history.

What are the rules of a letter of credit?

Letters of credit operate under internationally recognized rules, primarily:

• UCP 600 (Uniform Customs and Practice for Documentary Credits) – Issued by the International Chamber of Commerce (ICC), it outlines standard practices for banks and businesses involved in LC transactions.
  
• ISBP (International Standard Banking Practice) – Provides guidance on document examination under LCs.
  
• Local banking regulations may also apply depending on the countries involved.

These rules ensure consistency, fairness, and legal clarity in the use of letters of credit across global markets.