Letter of Credit

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Russian: Аккредитив


General Provisions

A Letter of Credit is a document in which the importer's bank essentially promises to pay the exporter if the importer does not pay. The creditworthiness of the bank is substituted for the creditworthiness of the importer. However, the concept is substantially more complex than this. The promise is not made upon the exporter meeting certain conditions (or the importer not meeting certain conditions), but it is made on the documents of the transaction: This is the reason why a Letter of Credit is often called a Documentary Letter of Credit. The bank is under no obligation to pay even though delivery has been made and the importer has obtained control of the merchandise; similarly, the bank has to pay even though the merchandise may be shoddy or not fit for sale. The bank is obligated to pay only if the documents are in order. The Letter of Credit is therefore a contractual agreement between the Issuing Bank and the beneficiary, independent of the underlying relationship between the exporter and the importer; only the documents relating to the exporter-importer transaction matter. This obviously means that extreme care must be taken in handling the documents related to a Letter of Credit; otherwise, it triggers a very time-consuming and expensive process of amendments and corrections to the Letter of Credit.[1]

The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 ("UCP") are rules that apply to any documentary credit ("credit") (including, to the extent to which they may be applicable, any standby letter of credit) when the text of the credit expressly indicates that it is subject to these rules. They are binding on all parties thereto unless expressly modified or excluded by the credit[2]

There are two types of Letters of Credit[3].

  • 1 - A revocable Letter of Credit can be revoked without the consent of the Exporter, meaning that it may be cancelled or changed up to the time the documents are presented. A revocable Letter of Credit affords the Exporter little protection; therefore, it is rarely used.
  • 2 - An irrevocable Letter of Credit cannot be cancelled or changed without the consent of all parties, including the Exporter. Unless otherwise stipulated, all Letters of Credit are irrevocable. A further differentiation is made between Letters of Credit, depending on the payment terms[4]. If payment is to be made at the time documents are presented, this is referred to as a sight Letter of Credit. Alternatively, if payment is to be made at a future fixed time from presentation of documents (e.g. 60 days after sight), this is referred to as a term, usance or deferred payment Letter of Credit.

There is more detailed Classification of Letters of Credit [5]designed and constructed in accordance with agreed level of security and the point in time at which risk is assumed and also their different types of use.

Diagram of Typical Simplified L/C Transaction Flow

L C EC.jpeg


0 Seller and Buyer [0] conclude a sales contract, with method of payment, for the first time, usually by Letter of Credit (documentary credit).

1 Buyer [1] applies to his issuing bank, usually in Buyer's country, for Letter of Credit in favor of Seller (beneficiary).

2 Issuing bank [2.1] requests another bank, usually a correspondent bank in Seller's country, to [2.2] confirm the Letter of Credit.

3 Issuing bank [3] requests another bank (sometimes a correspondent bank in Seller's country) to advise the credit.

4 Advising bank, usually in Seller's country, [4] forwards Letter of Credit to Seller informing about the terms and conditions of the Letter of Credit.

5 If credit terms and conditions conform to sales contract, Seller prepares [5.1] goods and documentation, and arranges delivery of goods to carrier, having received a clean Bill of Lading [5.2].

6 Seller presents [6] listed in the Letter of Credit documents (bill of lading, invoice, packing list, certificate of origin, etc.) evidencing the shipment (Bill of Lading) and by Letter of Credit to paying bank named in the Letter of Credit (the advising bank usually), or any bank willing to negotiate under the terms of the Letter of Credit.

7 Advising bank [7.1] examines the documents for compliance with terms of the Letter of Credit. If complied with, bank [7.2] will pay to Seller’s account according to terms of the Letter of Credit.

8 Advising bank [8] sends the documents to the issuing bank.

9 Issuing bank [9] examines the documents for compliance with terms of the Letter of Credit.

10 Documents [11] release to Buyer after [10] payment or on other terms agreed between the bank and Buyer.

11 Buyer [12] surrenders Bill of Lading to carrier (in case of ocean freight) in exchange for the [13] goods or the Delivery Order.

Advantages and Disadvantages of Using a Letter of Credit

Advantages of Using a Letter of Credit Disadvantages of Using a Letter of Credit Advantages of Using a Letter of Credit Disadvantages of Using a Letter of Credit
  • Importer is assured that the Exporter will be paid only if all terms and conditions of the Letter of Credit have been met.
  • Importer is able to negotiate more favourable trade terms with the Exporter when payment by Letter of Credit is offered.
  • A Letter of Credit does not offer protection [6] to the Importer against the Exporter shipping inferior quality goods and/or a lesser quantity of goods. Consequently, it is important that the Importer performs the appropriate due diligence to assess the reputation of the Exporter. If the Exporter acts fraudulently, the only recourse available to the Importer is through legal proceedings.
  • It is necessary for the Importer to have a line of credit with a bank before the bank is able to issue a Letter of Credit. The amount outstanding under each Letter of Credit issued is applied against this line of credit from the date of issuance until final payment.
  • The risk of payment relies upon the creditworthiness of the Issuing Bank and the political risk of the Issuing Bank’s domicile, and not the creditworthiness of the Importer.
  • Exporter agrees in advance to all requirements for payment under the Letter of Credit. If the Letter of Credit is not issued as agreed, the Exporter is not obligated to ship against it.
  • Exporter can further reduce foreign political and bank credit risk by requesting confirmation of the Letter of Credit by his or her domestic bank.
  • Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit.
  • Some Importers may not be able to open Letters of Credit due to the lack of credit facilities with their bank which consequently inhibits export growth.

Letter of Credit is the most expensive term of payment in international trade. Nevertheless, they state Letters of Credit have been a cornerstone of international trade dating back to the early 1900s. They continue to play a critical role in world trade today. For any company entering the international market, Letters of Credit are an important payment mechanism which help eliminate certain risks[7]. To make a right decision (or to analyze corresponding offers) concerning form/type of L/C, it is very important to understand better who are Parties to Letter of Credit and know main items of Documents Attached to Letter of Credit. See, also, Payment Risk in International Trade.


  1. Additional useful data concerning Letter of credit (terminology, sample documents, etc.) could be revealed at http://www.export911.com/e911/export/docLC.htm
  2. ICC Uniform Customs and Practice for Documentary Credits (UCP 600) - http://shippingandfreightresource.com/wp-content/uploads/2013/05/ucp-600.pdf
  3. A Guide to Letters of Credit - http://www.tradev.net/Downloads/Tools/guide2lc.pdf
  4. ibid
  5. ICC Uniform Customs and Practice for Documentary Credits (UCP 600) - http://shippingandfreightresource.com/wp-content/uploads/2013/05/ucp-600.pdf
  6. Added protection to the Importer may be provided by requesting additional documentation in the Letter of Credit, e.g. a Certificate of Inspection. An Inspection Certificate may be requested from a third party or an agent of the Importer located in the country of dispatch, to ensure a certain quality of goods. In this case, they must stipulate the issuer of such a Certificate and, if necessary, the content or wording of the Certificate, otherwise banks will accept such a document as presented. It is recommended that an Inspection Certificate be requested wherever possible.
  7. - A Guide to Letters of Credit - http:/ / www. tradev. net/ Downloads/ Tools/ guide2lc. pdf - p.2.
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