A letter of credit works by replacing the buyer’s promise to pay with a bank’s promise to pay. The buyer’s bank issues a written guarantee to the seller: if the seller ships the goods and hands over a specific set of documents that match the credit’s terms, the bank pays. The buyer then reimburses the bank. Banks typically charge 0.75% to 2% of the credit’s value for this guarantee, which is why letters of credit are standard in international trade where buyer and seller often have no basis to trust each other directly.
Who Is Involved
A standard letter of credit has three core parties and one or two supporting banks.
- The applicant is the buyer, who asks their bank to issue the credit and is ultimately responsible for reimbursing the bank.
- The beneficiary is the seller, who collects payment by presenting documents that match the credit’s terms.
- The issuing bank is the buyer’s bank. It creates the credit and takes on the primary obligation to pay.
- The advising bank sits in the seller’s country. It authenticates the credit and passes it to the seller, but it does not itself guarantee payment.
- A confirming bank is optional. When present, it adds its own payment guarantee on top of the issuing bank’s, so if the issuing bank fails to pay, the confirming bank does. Sellers dealing with a foreign issuing bank often insist on confirmation.
How the Process Runs, Step by Step
1. The Buyer Applies
The buyer takes the terms from the sales contract and fills out the issuing bank’s application. The application must include the exact purchase price and currency, the precise quantity and description of the goods, and the latest date by which the cargo must leave the port. It must also list every document the seller will need to present to get paid. Common requirements are the bill of lading (proof the goods were loaded), the commercial invoice, a certificate of origin, an insurance certificate, and, when the buyer wants quality protection, a third-party inspection certificate.
Accuracy matters here because banks apply a strict compliance standard at the other end. A small typo in the description of goods or a minor weight discrepancy can lead to rejection later. Under UCC 5-104, the credit must be in a recorded format and authenticated by signature or another agreed method, which allows electronic transmission.1Cornell Law School. Uniform Commercial Code 5-104 – Formal Requirements
2. The Bank Issues the Credit
The issuing bank evaluates the buyer’s creditworthiness the way it would for a loan, and it may require collateral or a cash deposit. Once approved, the bank generates the formal credit and transmits it through SWIFT, the global secure messaging network banks use for trade finance. Letters of credit travel as SWIFT Category 7 messages, typically the MT 700.2SWIFT. SWIFT Certified Application Trade Finance Technical Validation Guide
The advising bank receives the transmission, verifies its authenticity, and notifies the seller that the credit is in place. If confirmation was arranged, the confirming bank reviews the terms and adds its guarantee before that notification goes out. Once the seller has the notification, they can begin manufacturing or preparing the goods with the assurance that payment is backed by a bank.
3. The Seller Ships and Presents Documents
After shipping, the seller assembles the documents required by the credit and submits them to the designated bank. Presentation generally must happen within the window set in the credit, commonly 21 days after the shipment date.3FCIB Global. An In-Depth View of Letters of Credit Missing that deadline can cause the bank to treat the documents as discrepant and refuse payment, even if the goods arrived safely.
4. The Bank Examines the Documents
The bank reviews the paperwork on its face. It does not inspect the goods and does not judge the transaction; it compares documents to the credit. Under UCC 5-108, if the documents strictly comply with the credit’s terms, the bank must honor the presentation, and if they do not comply, it must dishonor it.4Cornell Law Institute. Uniform Commercial Code 5-108 – Issuers Rights and Obligations Under UCP 600, banks have up to five banking days to complete this examination.5ICC Academy. Documentary Credits: Rules, Guidelines and Terminology Under UCC Article 5, the window is up to seven business days.
5. Payment and Reimbursement
When the documents pass review, the issuing bank releases the funds to the seller’s bank for credit to the seller’s account. The buyer then reimburses the issuing bank for the amount paid plus fees. Once reimbursed, the bank releases the original shipping documents to the buyer, including the bill of lading, which the buyer needs to claim the goods at the destination port. If the buyer fails to reimburse, the bank retains a security interest in the goods as collateral.
Why the Bank Pays on Documents, Not on the Deal
The single feature that makes a letter of credit work as a payment tool is the independence principle. Under UCC 5-103(d), the bank’s obligation to the seller is independent of the underlying sales contract.6Cornell Law School. Uniform Commercial Code 5-103 – Scope A dispute between buyer and seller over quality or delivery does not affect the bank’s duty to honor compliant documents. The bank pays based on paperwork, not on whether the buyer is happy with the deal.
The principle cuts both ways. The seller cannot force payment by proving they shipped perfect goods; they must present the exact documents the credit requires. And the buyer cannot instruct the bank to withhold payment because they changed their mind or found a cheaper supplier.
There is one narrow boundary. Under UCC 5-109, if a required document is forged or materially fraudulent, or if honoring the credit would facilitate a material fraud by the seller, a court can enjoin payment.7Cornell Law School. Uniform Commercial Code 5-109 – Fraud and Forgery The fraud must be serious and clearly established. A buyer who is simply unhappy with the goods cannot invoke it. And even where fraud exists, courts will not block payment to a confirming bank or other nominated person that has already acted in good faith and given value.
What It Costs
Several fees stack up across the transaction, and the sales contract should say who pays what. In many international deals, the buyer covers the issuing bank’s fees and the seller covers the advising and confirming bank’s fees, but this is negotiable.
- The issuance fee charged by the issuing bank runs 0.75% to 2% of the credit’s value, depending on the buyer’s creditworthiness, the deal size, and the countries involved.
- A confirmation fee, if a confirming bank adds its guarantee, typically adds 0.25% to 2%, with higher fees for higher-risk countries.
- The advising fee is a flat charge from the advising bank for authenticating and forwarding the credit.
- Amendment fees run roughly $50 to $300 per change.
- Negotiation and document handling fees cover the bank’s examination and processing work.
When Documents Don’t Match
Discrepancies are common. A large share of first-time presentations contain errors of some kind. When a bank finds a discrepancy, it must send a single notice listing every problem it identified. It cannot reject on Monday for one reason and add a new reason on Wednesday.
The seller then has a few options:
- Correct the errors and re-present the documents, if the credit has not expired.
- Ask the buyer to instruct the issuing bank to waive the discrepancy. This is common for small problems.
- Request a formal amendment to the credit itself if the original terms caused the problem, for example an unrealistic shipping deadline.
Amendments require the consent of all parties. Neither buyer nor seller can change the terms unilaterally, and the issuing bank sends the amendment through the same SWIFT channels used for the original credit.
Which Rules Govern the Credit
Two overlapping frameworks apply. In the United States, UCC Article 5 is the primary law and has been adopted in some form in all 50 states. Internationally, most credits incorporate the ICC’s Uniform Customs and Practice for Documentary Credits (UCP 600). UCP 600 is not law by itself; the parties have to agree to apply it to their credit.5ICC Academy. Documentary Credits: Rules, Guidelines and Terminology UCC 5-116(c) specifically allows parties to adopt rules of custom or practice like the UCP, so the two systems work together. Where they differ, the credit itself controls: incorporate UCP 600 and the five-day examination window applies; leave it out for a domestic U.S. credit and the seven-day UCC window controls.
Common Variations
The basic mechanism above describes a standard commercial letter of credit, but several variations adjust it for different situations.
Irrevocable by default. Under UCC 5-106, a letter of credit is irrevocable unless it specifically says it can be revoked.8Cornell Law School. Uniform Commercial Code 5-106 – Issuance, Amendment, Cancellation, and Duration An irrevocable credit cannot be changed or canceled without the agreement of all parties, which prevents a buyer from pulling the guarantee after the seller has started production.
Standby. A standby letter of credit is a backup. The seller draws on it only if the buyer fails to pay through the normal method, and typically has to demonstrate that failure before the bank pays.
Revolving. For ongoing trading relationships with repeated shipments, the credit amount renews automatically after each payment, so the parties don’t apply for a new instrument every time.
Transferable and back-to-back. When a middleman sits between the actual buyer and the actual manufacturer, a transferable credit lets the intermediary pass the credit—partly or fully—to the supplier. It’s cheaper but limits the intermediary’s ability to change terms. A back-to-back structure uses two separate credits, with the buyer’s credit serving as collateral for a second credit issued to the supplier. It’s more flexible and more expensive.9ICC Academy. Transferable vs. Back-to-Back Letters of Credit: Key Risks and Mitigation Strategies for Banks