A letter of credit (LC), also called a documentary credit, is a bank’s conditional promise to pay a seller when the seller presents the documents required by the credit and meets its terms. The bank checks the paperwork—not the shipment—so an LC can support payment without guaranteeing that goods exist, arrive on time, or match the sales contract.
What a letter of credit does
In a typical international sale, the buyer asks a bank to issue an LC in the seller’s favour. The issuing bank undertakes to honour a presentation that complies with the credit. The seller therefore relies on the bank’s undertaking, subject to the credit’s documentary requirements, rather than only on the buyer’s promise to pay.
“Letter of credit” and “documentary credit” are commonly used as synonyms; the International Chamber of Commerce (ICC) rules generally use “documentary credit.” The arrangement is distinct from the underlying sale: under UCP 600 Article 4, the credit is a separate transaction, and a dispute between buyer and seller does not by itself change the bank’s undertaking. ICC UCP 600; ICC Academy: Documentary credits
Who is involved
- Applicant: Usually the buyer or importer, who requests that the credit be issued.
- Issuing bank: The bank that issues the credit and makes the undertaking to honour a complying presentation under its terms.
- Beneficiary: Usually the seller or exporter, in whose favour the credit is issued.
- Advising bank: A bank that advises the credit to the beneficiary at the issuing bank’s request. Advising it does not, by itself, add a payment promise from the advising bank.
- Nominated bank: The bank with which the credit is available, or any bank if the credit says so. It may receive documents and honour or negotiate as authorized under the credit.
- Confirming bank: A bank that adds its own undertaking to the issuing bank’s undertaking when confirmation is arranged.
The exact roles depend on the credit’s terms. An advising bank and a confirming bank are not interchangeable: only the latter adds its own payment undertaking.
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How a commercial letter of credit works
- Agree on payment terms. Buyer and seller agree to use an LC and settle the amount, expiry, shipment and presentation requirements, method of availability, and required documents in the sales arrangement.
- The buyer applies for the credit. The applicant asks its bank to issue the LC in favour of the seller. An advising bank may authenticate and advise the credit to the beneficiary.
- The seller performs and gathers documents. The seller ships or otherwise performs as agreed and obtains the documents specified in the credit. These may include an invoice and a transport document; an inspection certificate can be required if it is useful and realistically obtainable.
- The seller presents the documents on time. The beneficiary submits them to the issuing bank or a nominated bank, at the place and by the deadline stated in the credit.
- The bank examines the presentation. The bank checks the documents against the credit and applicable rules. If the presentation complies, the bank’s relevant honour or negotiation undertaking applies. If it does not, the bank may refuse it and give notice identifying discrepancies.
The credit must specify how it is available: by sight payment, deferred payment, acceptance, or negotiation. These are different payment mechanisms, so the seller should understand the selected method and timing rather than assume that every LC pays immediately.
What the bank checks—and what it does not
The central limitation is that banks deal with documents, not the underlying goods, services, or performance. UCP 600 Article 5 states: “Banks deal with documents and not with goods, services or performance to which the documents may relate.” ICC UCP 600
Accordingly, the bank does not independently inspect cargo or verify that the goods meet the sales contract. An LC is not a guarantee of delivery, quality, quantity, or even the goods’ existence. A buyer can require documents such as an inspection certificate, but the bank’s role remains examination of the presented documents under the credit—not an independent inspection.
Why documentary compliance matters
Payment depends on a complying presentation: the required documents must be presented as stipulated and within the credit’s deadlines. Incomplete, late, or inconsistent paperwork can be treated as discrepant and put payment under the credit at risk. A bank may refuse a discrepant presentation with notice of the discrepancies. ICC Academy: 11 questions about documentary credits
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- For buyers: Keep documentary conditions clear, necessary, and feasible for the seller to meet. Unworkable requirements can obstruct a valid payment presentation without resolving a dispute about the goods.
- For sellers: Review the issued credit promptly, check that its requirements match the sales agreement, and ensure each required document can be obtained and presented as specified.
When UCP 600 or eUCP applies
UCP 600 is the ICC’s 2007 revision of its Uniform Customs and Practice for Documentary Credits. It does not automatically govern every LC: Article 1 says the credit must expressly indicate that it is subject to UCP, and the credit may modify or exclude provisions. It is a rules framework incorporated into the credit, not a universal statute that applies by default. ICC UCP 600
For electronic presentation, the ICC’s eUCP supplements UCP 600 when the credit uses it. The ICC identifies eUCP version 2.1, dated 29 June 2023, as its digital companion for handling letters of credit in a digital environment. ICC eUCP version 2.1
How an LC differs from other payment instruments
| Instrument | What the bank does | Typical role and payment trigger |
|---|---|---|
| Documentary letter of credit | The issuing bank gives an undertaking to honour a complying documentary presentation. | Typically a primary payment mechanism; payment depends on presentation meeting the credit’s terms. |
| Documentary collection | Banks handle documents under collection instructions, such as documents against payment or acceptance, but do not give the same issuing-bank undertaking to pay. | A bank-mediated document process; the buyer’s payment or acceptance under the collection instructions is central. |
| Standby LC or demand guarantee | Provides secondary security, generally payable against a complying demand or presentation under its terms. | Typically used as backup protection rather than the primary payment method. ICC identifies ISP98 or UCP 600 as possible rules for standby credits when incorporated. |
These instruments are not interchangeable. The right arrangement depends on the contract, the parties, country and bank risk, and the precise terms issued. ICC Academy: Export financing
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.What an LC can and cannot protect against
An LC can reduce a seller’s reliance on an unfamiliar buyer by substituting the issuing bank’s undertaking for the buyer’s direct payment promise, provided the seller makes a complying presentation. If confirmation is arranged, a second bank adds its own undertaking. For the buyer, specified documents can make the payment process conditional on receiving the paperwork required by the credit.
Those protections do not eliminate bank, country, or documentary risk, and they do not settle whether the goods satisfy the sale contract. The sales contract should set out the agreed payment arrangement, and the credit should accurately reflect the parties’ documentary requirements. ICC Academy: Documentary credits
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