Letter of Credit Complete Guide: Types, Process, Documents and Risk Management

A Letter of Credit (LC) is one of the safest payment instruments in international trade — when used correctly. For exporters, an LC replaces the buyer's promise to pay with the buyer's bank's promise to pay, conditional on the exporter presenting compliant documents. This guide explains every stage of an LC transaction, the types, the document-checking process and how to minimise discrepancies.

What is a Letter of Credit?

An LC is a written undertaking by a bank (the issuing bank), on behalf of the buyer (applicant), to pay the seller (beneficiary) a specific sum within a defined time, against presentation of conforming documents as specified in the LC.

The LC is governed by **UCP 600** (Uniform Customs and Practice for Documentary Credits), published by the International Chamber of Commerce, and is recognised in over 175 countries.

Parties to an LC

• **Applicant** — the buyer who requests the LC.
• **Beneficiary** — the exporter who receives payment.
• **Issuing bank** — the buyer's bank that issues the LC.
• **Advising bank** — the bank in the exporter's country that authenticates the LC.
• **Confirming bank** — adds its own payment undertaking (used when the issuing bank's country is high-risk).
• **Reimbursing bank** — settles the claim between banks (where nominated).
• **Negotiating bank** — purchases the documents from the beneficiary.

Types of LC

• **Irrevocable LC** — cannot be cancelled or amended without beneficiary consent. Standard under UCP 600.
• **Revocable LC** — rare; can be amended/cancelled without notice.
• **Sight LC** — payment on presentation of compliant documents.
• **Usance LC** — payment at a fixed period after presentation (e.g., 60 days from B/L date).
• **Confirmed LC** — confirming bank adds its undertaking; preferred for higher-risk countries.
• **Transferable LC** — beneficiary can transfer part or all to a second supplier (useful for merchant exporters).
• **Back-to-back LC** — two separate LCs; one backed by another.
• **Revolving LC** — reinstates after each utilisation, for repeat shipments.
• **Red Clause LC** — allows pre-shipment advance to the beneficiary.
• **Green Clause LC** — advance plus warehousing of goods before shipment.

How an LC transaction flows

1. 1Buyer and seller agree to LC terms in the contract / Proforma Invoice.
2. 2Buyer applies to its bank (issuing bank) with the agreed LC text.
3. 3Issuing bank issues the LC and sends it to the advising bank.
4. 4Advising bank authenticates and forwards the LC to the beneficiary.
5. 5Beneficiary ships the goods and prepares documents.
6. 6Beneficiary presents documents to the negotiating/advising bank.
7. 7Negotiating bank checks documents against the LC. If compliant, pays or forwards to issuing bank.
8. 8Issuing bank checks documents. If compliant, reimburses the negotiating bank and releases documents to the buyer.
9. 9Buyer takes delivery of goods using the documents.

Document checking — the heart of an LC

Under UCP 600, banks examine documents "on their face" — strictly against the LC terms. They do not inspect the goods. Even minor discrepancies can delay or block payment.

Typical documents required:

• Commercial invoice.
• Packing list.
• Full set of negotiable Bill of Lading (or airway bill).
• Certificate of Origin.
• Insurance policy / certificate.
• Inspection certificate (e.g., SGS, Intertek).
• Phytosanitary / health certificate (for food).
• Certificate of Analysis (for chemicals).
• Beneficiary's certificate.

Common discrepancies that block payment

• Late shipment (after the latest shipment date in the LC).
• B/L consigned incorrectly (e.g., to order when LC requires "to order of issuing bank").
• Missing signatures or stamps on documents.
• Insurance coverage below LC requirement (typically 110% of CIF value).
• Documents inconsistent with each other (e.g., invoice says 1000 cartons, packing list says 995).
• Trade terms (FOB/CIF) not mentioned on invoice.
• Port of loading / discharge differs from LC.
• Presentation after the 21-day window from B/L date (or LC-specified window).

> Even a single discrepancy can give the issuing bank grounds to refuse payment. Treat document preparation as carefully as production itself.

How exporters reduce LC risk

• **Negotiate the LC text** with the buyer before issuance. Never accept terms you cannot meet.
• **Insist on a confirmed LC** for buyers in higher-risk countries.
• **Ensure the LC allows enough time** for shipment and document presentation.
• **Use a transferable LC** if you are sourcing from a third-party manufacturer.
• **Pre-check drafts** with your bank before the LC is finalised.
• **Use a CHA and forwarder who understand LC requirements** — they ensure shipping documents are clean.
• **Stage document preparation** — start the day after shipment, not the day before presentation.

Costs in an LC transaction

• Issuance charges (paid by applicant, typically 0.1–0.25% of LC value).
• Advising charges (paid by beneficiary).
• Confirmation charges (where applicable, 0.5–2% of LC value).
• Negotiation / discrepancy / amendment fees.
• Reimbursement charges.

For small shipments, LC costs can eat into margin — discuss the cost-sharing with the buyer upfront.

When to use an LC vs other payment methods

• **Advance TT** — best for small first orders or trusted buyers; exporter is fully protected.
• **LC at sight** — balanced protection; preferred for new buyers and mid-size shipments.
• **DP (Documents against Payment)** — buyer pays before documents are released; less secure than LC.
• **DA (Documents against Acceptance)** — buyer accepts documents and pays later; exporter bears risk.
• **Open account** — buyer pays after delivery; exporter bears maximum risk.

FAQ

**Q: Is an LC payment guaranteed?** A: An LC is a bank undertaking — but only against compliant documents. If documents have discrepancies, the bank can refuse to pay.

**Q: What is the difference between sight and usance LC?** A: Sight LC pays on presentation of documents. Usance LC pays after a defined period (e.g., 60 days from B/L date).

**Q: Can an LC be cancelled?** A: An irrevocable LC cannot be cancelled or amended without the beneficiary's consent.

**Q: What is a confirmed LC and when is it needed?** A: A confirmed LC adds a second bank's payment undertaking. It is recommended when the issuing bank is in a higher-risk country.

Key Takeaways

• An LC replaces the buyer's promise with the issuing bank's promise, conditional on compliant documents.
• UCP 600 governs LCs in 175+ countries.
• Banks examine documents "on their face" — minor discrepancies can block payment.
• Always negotiate LC text before issuance; never accept terms you cannot meet.
• Use confirmed LCs for higher-risk buyer countries; transferable LCs for merchant exporters.

Blueroute Exim (Surat, Gujarat) works with buyers on advance TT and LC at sight terms, and can structure shipments to meet strict LC document requirements.