How do Letters of Credit Work

A letter of credit is a document, normally issued by a bank or financial institution, that authorizes the recipient of the letter (the customer of the bank) to draw amounts of money up to a specified total, consistent with any terms and conditions set forth in the letter. In simple terms, a letter of credit documents a bank customer's line of credit, and any terms or restrictions associated with its use of that line of credit.

The Letter of Credit

A letter of credit is most often obtained by a recipient who wants to purchase goods, in order to assure a seller (the beneficiary) that it will receive payment for any goods it sells to the customer. Letters of credit are most commonly used in association with long-distance and international commercial transactions.

A financial institution may impose restrictions on the letter of credit to ensure that it is being appropriately by the recipient. For example, a bank might extend the letter of credit conditioned upon the beneficiary's provision of documentation that the goods purchased with the line of credit have been shipped to the recipient customer.

The customer may use the letter of credit to assure the beneficiary that, if it satisfies the conditions set forth in the letter, it will be paid for any goods it sells and ships to the customer, but the bank does not have to issue payment until it has confirmed that the transaction has been completed.

Types of Letters of Credit

Letters of credit come in a variety of forms, some of which may be combined, in order to better suit the recipient's purposes. Varieties of letter of credit include:

Confirmed Letter of Credit

A letter of credit, issued by a foreign bank, that has been verified and guaranteed by a domestic bank in the event of default by the foreign bank or buyer. This form of letter of credit will most often be sought when a domestic exporter seeks assurance of payment from a foreign importer.

Commercial Letter of Credit

A commercial letter of credit assures the seller that the bank will provide payment for any goods or merchandise shipped to the bank's customer, assuming the seller provides any required documentation of the transaction and its shipment of the purchased goods.

Irrevocable Letter of Credit

An irrevocable letter of credit includes a guarantee by the issuing bank that if all of the terms and conditions set forth in the letter are satisfied by the beneficiary, the letter of credit will be honored.

Revocable Letter of Credit

A revocable letter of credit may be cancelled or modified by the issuing bank after its date of issue. A seller that is presented with a revocable letter of credit should confirm its continuing validity before relying upon the letter.

Standby Letter of Credit

A standby letter of credit is similar to a guarantee, as it protects the recipient in the event that the recipient defaults. If the bank's customer defaults on a payment to the beneficiary, once the beneficiary documents proof of its loss consistent with any terms set forth in the letter, a standby letter of credit may be used by the beneficiary to secure payment from the issuing bank.

The issuance of standby letters of credits falls under a set of rules adopted under the Uniform Customs and Practice for Documentary Credits (UCP), which have been adopted by financial institutions in more than 175 countries.

Revolving Letter of Credit

When a buyer wants to receive deliveries of goods it has ordered in installments, it can seek a revolving letter of credit. The letter of credit guarantees the payment for the value of each installment, as it is made. The issuing bank is liable for the value of goods shipped to the buyer, and normally will be liable for any shipments made even if the full contract is not completed. The bank is liable for a new delivery only after the prior delivery has been delivered and paid for, and is not responsible for the value of goods that are not actually shipped to the buyer. Once the conditions of the letter of credit have been met, it becomes irrevocable.

Transferable Letter of Credit

A transferable letter of credit may be transferred by the original recipient to an intermediary. For example, during an international transaction, the original recipient may transfer the letter of credit to an intermediary who can then use the letter of credit to complete transactions on behalf of the original recipient, without having to rely upon its own credit or financial resources.

Red Clause Letter Credit

Sometimes a seller will not be willing or able to obtain or manufacture goods without an initial payment from the buyer. Under a red clause letter of credit, a seller may request an advance of funds up to an agreed amount from the issuing bank, prior to delivering any goods, effectively financing the seller's manufacture or acquisition of the goods for the benefit of the recipient buyer. The amount advanced is normally credited against the agreed purchase price when the goods are shipped or delivered.

Green Clause Letter of Credit

A green clause letter of credit permits a seller to request an advance upon documenting that the goods that are to be shipped to the recipient buyer have been warehoused, upon presenting warehouse receipts to document that the goods are in place and ready for shipment.

Issuance of Payment Under a Letter of Credit

When a letter of credit is used in a transaction, the letter will describe when payment becomes due to the seller. Common terms include:

  • Payment on Sight: The recipient seller is entitled to payment immediately after it provides documentation to the issuing bank establishing that the terms of the letter have been met. Following receipt the bank may withhold payment for a reasonable time, not to exceed five business days, in order to verify the documents.

  • Deferred Payment: The recipient seller documents to the bank that it has met the terms of the letter of credit, but payment is not due until a later date specified in the letter of credit. In parts of Asia a letter of credit with deferred payment is known as a usance letter of credit.

  • Payment Upon Acceptance: As with deferred payment, payment does not become due under a letter of credit that provides for payment upon acceptance until a date specified in the letter of credit, even though the bank has previously received documentation that the terms of the letter of credit have been satisfied. The seller may request a discounted payment at an earlier date, receiving the payment due for the goods less the amount of the discount applied for early payment.

  • Negotiable Credit: A negotiable letter of credit obligates the issuing bank to pay not only the recipient, but also to pay any bank or financial institution designated by the beneficiary. A negotiable letter of credit can be transferred between parties, allowing the original beneficiary to use the letter of credit in a manner similar to cash. In order to be negotiable, a letter of credit msut include an unconditional promise of payment, either on demand or at a definite time.

Letter of Credit Transactions

Although the exact process may vary, the following process is typical for a letter of credit transaction between an importer and an exporter of goods:

  1. The importer enters into a contract to purchase goods from an exporter and a purchase order is issued;
  2. The importer contacts a bank (the issuing bank) to request a letter of credit and the bank reviews the applicant's eligibiity and creditworthiness;
  3. If the bank approves the letter of credit, the exporter will work with a confirming bank that will obtain letter of credit documents from the issuing bank.
  4. The confirming bank verifies the terms of the letter of credit and, if approved, the exporter may ship the goods subject to the letter of credit;
  5. The exporter provides shipping documents to the confirming bank to prove that the goods have been shipped;
  6. The confirming bank reviews the shipping documents to verify that they fullly comply with the terms of the letter of credit;
  7. If the shipping documents are satisfactory, the confirming bank forwards the documents on to the issuing bank;
  8. The importer makes payment to the issuing bank;
  9. Upon receipt of payment, the issuing bank releases the shipping documents so that the importer can obtain the imported goods;
  10. The issuing bank transfers payment to the confirming bank which, in turn, transfers payment to the exporter.
Copyright © 2004 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Apr 6, 2018.