A Letter of Credit (LC), also called a documentary credit, is a bank undertaking to honour a complying presentation of documents under the terms of the credit. It is used in some international sales to manage payment risk between buyers and sellers who may not have a long trading history. An LC is document-based: banks examine the documents presented under the credit rather than physically inspecting the goods.
The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits, UCP 600, applies when the credit expressly states that it is subject to those rules. The ICC Library provides the text and related resources. Importers should work with their bank and trade-finance adviser to structure a credit that matches the contract, shipment plan and documentary capabilities of the seller.
1. Main parties in a documentary credit
- Applicant: normally the buyer or importer who asks its bank to issue the credit.
- Issuing bank: the bank that issues the credit at the applicant’s request.
- Beneficiary: normally the seller or exporter in whose favour the credit is issued.
- Advising bank: the bank that advises the credit to the beneficiary, commonly through a bank in the seller’s country.
- Confirming bank: a bank that adds its own undertaking to honour or negotiate a complying presentation where confirmation is requested and agreed.
- Nominated bank: the bank with which the credit is available, subject to the wording of the credit.
2. How an LC transaction typically works
The buyer and seller first agree the sales contract, product specification, delivery term, shipment window, payment method and required documents. The buyer applies to its issuing bank for the LC and provides the necessary credit information and security. The issuing bank issues the credit and sends it through the banking network to the advising bank, which advises it to the seller.
The seller reviews the credit before production or shipment. If terms are not workable, the seller should request an amendment through the banking channel rather than assume that a buyer email changes the credit. After dispatch, the seller presents the required documents within the credit’s presentation period. The bank checks whether the presentation complies with the credit and applicable rules. If the presentation complies, the bank honours or negotiates according to the credit’s availability terms; if discrepancies exist, the documents may be refused or submitted for waiver or other handling in accordance with the rules and banking process.
3. Common payment structures
A credit may be available by sight payment, deferred payment, acceptance or negotiation, depending on its wording. A sight credit is intended for payment upon a complying presentation and the required examination process. A deferred-payment structure postpones payment until a stated maturity. Acceptance involves a time draft accepted under the credit terms. Negotiation involves the nominated bank purchasing drafts and/or documents under the credit in accordance with the terms. The precise effect, financing cost and recourse should be confirmed with the bank.
4. Documents commonly required under an LC
The credit may call for a commercial invoice, packing list, transport document, certificate of origin, insurance document, inspection certificate, packing declaration or other documents. The required list depends on the transaction and should be realistic for the seller to obtain. Each document’s issuer, content, number of originals or copies, consignee, notify party, description, dates and presentation format should be checked when the credit is drafted.
Product and shipping descriptions should be consistent across the credit and stipulated documents. Overly detailed descriptions, impossible certification wording, conflicting date requirements or an incorrect transport-document instruction can cause discrepancies. The buyer and seller should review a draft credit before issuance where the bank permits this, and the seller should promptly check the issued credit before shipment.
5. Document discrepancies and common causes
- Invoice or transport document descriptions do not match the credit’s required wording.
- Shipment date or latest presentation date is missed.
- Documents are issued by a party not permitted by the credit.
- Required signatures, stamps, originals or copies are missing.
- Consignee, notify party, port, destination or transport details are inconsistent.
- Insurance amount, currency, risk coverage or date does not comply with the credit.
- Inspection or origin certificates contain an incorrect product description or issuer detail.
6. Plan the credit before the goods are ready
Do not wait until shipment to discover that a required certificate or document cannot be produced. Map the credit terms to the order calendar: order confirmation, production, inspection, export clearance, booking, shipment, document issuance and presentation. If a third-party inspection certificate is required, confirm the inspection provider, report wording and issue timeline before booking the visit. If a certificate of origin is required, verify the issuing process and timing with the competent organisation.
7. Letter of Credit versus other payment methods
Other payment methods can include advance payment, open account, documentary collection or a mix of deposits and balance payments. Each has a different risk, cost and cash-flow profile. An LC involves bank charges, document preparation, bank examination and possible amendment or discrepancy costs. It does not guarantee the physical quality of goods or eliminate all fraud, sanctions, performance or country risks. The buyer should compare the bank’s credit requirements and the seller’s ability to meet the documentary terms.
8. Questions for the buyer’s bank and trade-finance adviser
- Which UCP or eUCP rules apply and are they expressly incorporated?
- Who is the applicant, beneficiary, issuing bank, advising bank and confirming bank?
- How is the credit available: sight payment, deferred payment, acceptance or negotiation?
- What documents are required and who can issue each one?
- What is the latest shipment date and document presentation period?
- What bank charges, collateral, credit limits and amendment costs apply?
- How are discrepancies, waivers and document refusals handled?
- Do the credit terms match the purchase contract, Incoterm and actual logistics route?
How Vanguard Sourcing can support document coordination
Within an agreed project scope, Vanguard Sourcing can coordinate supplier-side production and packing information, follow up agreed inspection or certificate documents, and communicate shipment-readiness details with the buyer and its appointed bank or logistics providers. The buyer, seller, banks and qualified trade-finance advisers remain responsible for drafting, issuing, advising, confirming and interpreting the LC. Vanguard Sourcing is not a bank or trade-finance adviser.
Official references: ICC UCP 600 rules and ICC Academy documentary-credit terminology.