Letters of Credit (LC)
International trade finance instrument - Types, workflow, and UCP 600 guidelines explained.
What is a Letter of Credit?
A Letter of Credit (LC) is a binding document issued by a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. Governed by international regulations (UCP 600), LCs operate on the principle of autonomy, meaning the bank deals exclusively in documents, not in the physical goods themselves. It serves as the supreme instrument of financial security in international trade.
LC Workflow
- 1Applicant (Importer) requests the Issuing Bank to open the credit
- 2Issuing Bank transmits LC to Advising Bank in seller's jurisdiction
- 3Advising Bank informs Beneficiary (Exporter) about the LC
- 4Beneficiary ships goods and presents compliant shipping documents to the bank
- 5Bank verifies documents and triggers release of funds
Types of Letters of Credit
Sight Credit
Payment is executed immediately upon presentation of compliant shipping documents to the bank.
Usance / Time Credit
Payment is deferred to a specified future date (e.g., 60 days post-shipment), allowing the buyer time to sell the goods before paying.
Confirmed Credit
A second bank (usually in exporter's country) adds its distinct guarantee, mitigating risks associated with the issuing bank or geopolitical location.
Standby Letter of Credit (SBLC)
Functions essentially as a fail-safe or insurance policy. Only invoked and paid if the buyer explicitly defaults on contractual obligations.
Red Clause Credit
Contains a provision authorizing the advising bank to provide pre-shipment cash advances to the exporter, financing manufacturing or procurement.
Back-to-Back LC
Used by intermediaries; second LC opened based on the first LC as security.
Key Parties in LC
| Party | Role |
|---|---|
| Applicant | Importer who requests LC issuance |
| Beneficiary | Exporter who receives payment |
| Issuing Bank | Applicant's bank that issues LC |
| Advising Bank | Bank in beneficiary's country that notifies LC |
| Confirming Bank | Adds its guarantee to the LC (optional) |
| Negotiating Bank | Pays beneficiary and seeks reimbursement |
UCP 600 Guidelines
Uniform Customs and Practice for Documentary Credits (UCP 600) is the international standard governing LCs, published by the International Chamber of Commerce (ICC).
- • Banks deal only with documents, not goods or services
- • Documentary compliance is strict - discrepancies lead to rejection
- • 5 banking days for document examination
- • LC is irrevocable unless specifically stated otherwise
Common Documents Required
- •Bill of Lading (B/L): Proof of shipment and title to goods. Can be clean (no defects noted) or claused (defects noted).
- •Commercial Invoice: Detailed billing for goods including description, quantity, price, and terms.
- •Packing List: Details of package contents, weights, and dimensions for customs and handling.
- •Certificate of Origin: Certifies country of manufacture, required for customs duty determination.
- •Insurance Certificate: Coverage for goods in transit as per Incoterms (typically 110% of CIF value).
- •Inspection Certificate: Quality verification by third-party inspector (SGS, BV, etc.)
Costs Associated with Letters of Credit
| Charge Type | Typical Cost | Borne By |
|---|---|---|
| LC Issuance Fee | 0.1% - 0.5% of LC value (min ₹1,000-5,000) | Applicant (Importer) |
| Advising Fee | ₹500 - 2,000 | Beneficiary (Exporter) |
| Confirmation Fee | 0.5% - 2% of LC value | Beneficiary (or Applicant if agreed) |
| Amendment Charges | ₹500 - 2,000 per amendment | Party requesting amendment |
| Negotiation/Discounting | 0.5% - 2% plus interest | Beneficiary |
| Discrepancy Fee | ₹2,500 - 5,000 per discrepancy | Beneficiary |
LC Risks and Mitigation Strategies
Common Risks
- • Document discrepancies leading to rejection
- • Issuing bank credit risk (country/political risk)
- • Fraudulent documents or goods
- • Force majeure events
- • Currency fluctuation risk
- • Time delays in document processing
Mitigation Measures
- • Use confirmed LC for high-risk countries
- • Engage experienced freight forwarders
- • Obtain pre-shipment inspection certificates
- • Include force majeure clauses
- • Use forward contracts for currency hedging
- • Submit documents well before expiry
Digital Letters of Credit (e-LC)
Digital transformation is revolutionizing trade finance. Electronic LCs (e-LCs) use blockchain and digital platforms to reduce processing time from days to hours.
Benefits of e-LC
- • Faster processing (hours vs days)
- • Reduced paperwork and manual errors
- • Real-time tracking of LC status
- • Lower costs (no courier, reduced manpower)
- • Enhanced security and fraud prevention
- • Better compliance with UCP 600 e-rules
Leading Digital Trade Finance Platforms
- • Contour: Blockchain-based LC platform
- • TradeLens: IBM-Maersk blockchain platform
- • we.trade: European bank consortium platform
- • SWIFT gpi: Enhanced cross-border payments
LC vs Other International Payment Methods
| Method | Risk to Exporter | Risk to Importer | Best For |
|---|---|---|---|
| Letter of Credit | Low (bank guarantee) | Medium (document-based) | High-value, new trading relationships |
| Documentary Collection (D/P, D/A) | Medium | Medium | Established relationships, moderate risk |
| Open Account | High (credit risk) | Low (pay after receipt) | Trusted partners, intra-company trade |
| Advance Payment | Low (payment received) | High (no delivery guarantee) | First-time orders, high-risk countries |