A letter of credit is a written promise from a bank to pay a seller on the buyer's behalf, as long as the seller presents the exact documents the letter requires. The bank, not the buyer, guarantees payment, which is what makes the instrument so useful when two businesses do not know or trust each other, especially across borders. It is often shortened to LC or L/C and is sometimes called a documentary credit.
The whole point is to swap the buyer's credit risk for a bank's. The seller ships knowing a bank stands behind payment; the buyer knows the bank will only release funds once the agreed shipping and quality documents are produced. Neither side has to take the other on faith. That balance is why letters of credit remain a backbone of international trade finance, even though they add cost and paperwork. For finance teams, the trade-off is straightforward: more security in exchange for bank fees, tighter document discipline and a slower process than paying on open account.
A bank guarantees payment.The buyer's bank promises to pay the seller once the required documents are presented.
Documents, not goods.Banks check paperwork against the letter's terms, not the shipment itself, so accuracy is everything.
Built for trade.It lets exporters and importers transact safely when they cannot rely on each other's credit.
A letter of credit moves through a fixed sequence, from the sales contract to final payment. Each step swaps risk between the parties until the seller is paid and the buyer has its documents.
The sales contract states that payment will be made by letter of credit, fixing price, goods and the documents required.
The buyer applies to its bank, the issuing bank, which opens the letter of credit in the seller's favour.
The seller ships the goods, then submits the invoice, transport and any other documents to its bank, the advising or nominated bank.
The banks examine the paperwork against the letter's exact terms. If it complies, payment is approved; if not, the buyer must agree to accept the discrepancies.
The seller receives payment, the buyer reimburses its bank, and the buyer collects the documents needed to claim the goods.
Because payment turns entirely on the documents, a tiny mismatch (a misspelled name, a late shipment date, a missing certificate) can stall the whole thing. Sellers who rely on letters of credit usually invest in tight document control for exactly this reason. For domestic trade where you extend credit directly, robust accounts receivable software often does the job at a fraction of the cost and effort.
A letter of credit normally involves four parties: the buyer (applicant), the seller (beneficiary), the buyer's issuing bank, and the seller's advising bank. Knowing who does what makes it far easier to chase a delayed payment, because you can see exactly where in the chain a document is stuck.
Requests the credit from its bank and ultimately pays. The whole arrangement exists to protect the seller while letting the buyer keep its cash until shipment.
Receives payment once the documents comply with the letter's terms. The credit is opened in the seller's favour.
The buyer's bank that opens the letter and carries the obligation to pay the seller against compliant documents.
In the seller's country, it passes the credit on and checks that it is genuine before the seller relies on it.
A fifth party, a confirming bank, may add its own guarantee when the seller wants extra security, and freight forwarders or inspection agencies often supply the documents the banks rely on. Each link in that chain is a place a document can stall, so knowing the roles turns a vague "where is our money" into a specific question you can actually answer.
Use a letter of credit when the deal is large, the parties do not know each other, or the trade crosses a border with real payment or political risk. It is overkill for routine domestic sales to customers you trust, where the cost and paperwork outweigh the protection. The trade-off is genuine on both sides, so it helps to weigh the security it buys against what it costs to run.
The seller gets a bank's promise to pay rather than relying on the buyer's word.
The seller can often use the LC to raise finance against a confirmed sale.
The buyer keeps its cash until the goods are shipped and documented.
Fees fall on both sides, adding real cost to the transaction.
Strict document requirements cause delays whenever something is wrong.
The process ties up time and bank lines compared with open account.
Many growing businesses use letters of credit only for new or high-risk overseas customers, then move to open-account terms backed by good collections once trust is established. The LC is a starting position, not a permanent one: as a relationship proves itself, the cost and friction stop being worth it.
The most important distinction is between an irrevocable letter of credit, which cannot be changed without everyone's agreement, and a revocable one, which can; almost all modern LCs are irrevocable. Beyond that, the common variants each solve a specific problem, and the right one depends on how much certainty the seller needs and how the trade is structured. The table below covers the types you are most likely to meet, what each one does, and when it tends to be used.
| Type | What it does | Best for |
|---|---|---|
| Irrevocable | Cannot be amended or cancelled without all parties agreeing. | Almost all trade; the default standard. |
| Confirmed | A second bank (usually in the seller's country) adds its own guarantee. | Sellers worried about the issuing bank or country risk. |
| Standby | A backup that pays only if the buyer fails to pay by other means. | A safety net, similar to a bank guarantee. |
| Revolving | Reinstates automatically for repeat shipments under one facility. | Ongoing supply relationships. |
| Transferable | Lets the seller pass all or part of the credit to another supplier. | Intermediaries and traders. |
A letter of credit is a primary payment mechanism that pays the seller on presentation of compliant documents, while a bank guarantee is a fallback that pays only if one party defaults on its obligation. With an LC, the bank expects to pay in the normal course of the deal. With a guarantee, the bank only pays when something goes wrong. A standby letter of credit blurs the line, behaving much like a guarantee, which is why the two are often confused. Both shift risk onto a bank, but the trigger for payment is different.
A letter of credit is also a form of secured credit in spirit: the seller is not relying on the buyer's word, but on a guarantee backed by a bank's balance sheet. Compare it with trade credit insurance, which covers the seller against non-payment across a whole book rather than guaranteeing a single transaction, and with a bill of exchange, a written order to pay that often travels alongside an LC. Each tool manages the same underlying worry, that the money will not arrive, in a different way.
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