Letter of Credit (L/C)

A Letter of Credit (L/C) is a financial instrument issued by a bank on behalf of a buyer (applicant), guaranteeing that the seller (beneficiary) will receive payment for goods or services provided, as long as the terms and conditions specified in the L/C are strictly complied with and evidenced by the presentation of stipulated documents within a specified timeframe. The L/C serves as a payment and security mechanism in international trade, mitigating risks arising from differing legal systems and commercial practices between trading partners. The most common type is the Irrevocable Letter of Credit, which cannot be amended or cancelled without the agreement of all parties involved. An L/C operates under standardized rules, principally the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce (ICC).

Function in International Trade:

L/Cs bridge trust gaps between buyers and sellers in different countries, ensuring the seller receives payment as long as documentary conditions are satisfied and providing the buyer with security that payment will only be made upon proof of shipment or service.

Parties Involved:

• Applicant: The buyer in the transaction, who requests the bank to issue the L/C.
• Beneficiary: The seller or exporter, as the recipient of payment under the L/C.
• Issuing Bank: The buyer’s bank, which issues the L/C.
• Advising Bank: Usually the seller’s bank, which advises the seller of the L/C issuance.
• Confirming Bank (optional): A bank that adds its own undertaking to pay the beneficiary, further reducing risk.

Types of L/C:

• Irrevocable L/C: Cannot be amended or cancelled without consent from all parties (most common type).
• Revocable L/C: Can be amended or cancelled by the issuing bank at any time (rarely used).
• Confirmed L/C: A confirming bank adds its guarantee of payment.
• Sight L/C / Usance L/C: Specify payment at sight or after a deferred period.

Governing Rules:

L/Cs are typically governed by the Uniform Customs and Practice for Documentary Credits (UCP 600) established by the International Chamber of Commerce (ICC).

Risk Mitigation:

By ensuring payment is only made when exact documentation is provided, L/Cs protect both buyer and seller from default, non-performance, or fraud.