Letters of Credit Explained

A letter of credit is a bank's written guarantee that a buyer's payment to a seller will be received on time and for the correct amount, with the issuing bank stepping in to pay the seller if the buyer fails to do so. Letters of credit are one of the oldest and most widely used tools in international trade finance, addressing the fundamental trust problem that arises when a buyer and seller in different countries, with no established relationship and different legal systems, need to transact with confidence.

Why letters of credit exist

In a typical international trade transaction, a seller wants payment before releasing goods, while a buyer wants to receive and verify the goods before paying — a standoff that, without some trusted intermediary, can prevent a transaction from happening at all. A letter of credit solves this by substituting the buyer's bank's creditworthiness for the buyer's own promise to pay: the buyer's bank (the issuing bank) commits to pay the seller, provided the seller presents documents proving it has shipped the goods exactly as specified in the letter of credit's terms. This shifts the seller's risk from "will this specific buyer pay me" to "will this bank honour its documentary commitment," which is typically a far lower risk, particularly when the issuing bank is a well-established institution.

How the process works

The buyer applies to its bank for a letter of credit in favour of the seller, specifying the exact documents the seller must present to receive payment, typically including a bill of lading (proof of shipment), a commercial invoice, and often a certificate of origin or inspection certificate. Once the letter of credit is issued, the seller ships the goods and presents the required documents, usually through its own bank (the advising or negotiating bank), to the issuing bank. If the documents match the letter of credit's terms exactly — a principle known as strict compliance — the issuing bank is obligated to pay, regardless of any separate dispute between buyer and seller about the underlying goods themselves. This document-based, rather than goods-based, payment trigger is a defining feature of how letters of credit operate.

Variations: confirmed, standby, and revolving letters of credit

Several variations extend the basic structure. A confirmed letter of credit adds a second bank's guarantee (typically the seller's own bank) on top of the issuing bank's commitment, giving the seller protection even against the risk that the issuing bank itself, often in a country with higher political or banking risk, fails to pay. A standby letter of credit functions more like a financial guarantee, only drawn upon if the buyer fails to pay through normal means, rather than being the primary payment mechanism itself. A revolving letter of credit automatically renews for a further shipment once a previous drawing is settled, useful for buyers and sellers with an ongoing, repeated trading relationship rather than a single one-off transaction.

Relevance to working capital management

For finance professionals, letters of credit matter beyond their role in facilitating trade: they also affect a company's working capital position, since the buyer typically needs to post cash collateral or use available credit facility capacity to have its bank issue the letter of credit, tying up resources that could otherwise be deployed elsewhere. Understanding how letters of credit interact with a company's broader trade finance and working capital strategy is a core skill for corporate treasury and finance professionals managing international supply chains.

FAQ

Does a letter of credit guarantee the goods will be the right quality?

No — the issuing bank's obligation is based on the documents presented matching the letter of credit's terms, not on physically verifying the goods, which is why strict document compliance is so central to how letters of credit function.

Who pays the fees for a letter of credit?

Typically the buyer (the applicant) pays the issuing bank's fees, though the specific allocation of fees between buyer and seller can be negotiated as part of the underlying trade contract.

Are letters of credit still widely used given modern payment technology?

Yes — despite advances in digital payments, letters of credit remain heavily used in international trade, particularly for transactions involving counterparties in jurisdictions with higher commercial or political risk, where the bank-backed guarantee still provides meaningful value.

Finance professionals studying trade finance and working capital management can build this expertise through Learnsignal's CPD courses, which cover international trade and treasury topics in depth.

Documentary collections: a lower-cost alternative

Not every trade transaction needs the full weight of a bank payment guarantee. A documentary collection is a lighter-touch alternative in which banks handle the shipping documents and collect payment on the seller's behalf, but without the issuing bank's own payment guarantee that defines a letter of credit. The seller's bank sends the shipping documents to the buyer's bank, which releases them to the buyer only once the buyer pays (documents against payment) or formally accepts a bill of exchange committing to pay later (documents against acceptance). Because there is no bank guarantee behind a documentary collection, it is considerably cheaper than a letter of credit, but it leaves the seller more exposed if the buyer simply refuses to pay once the documents are available — making documentary collections better suited to trading relationships with an established level of trust than to first-time or higher-risk counterparties.

Letters of credit alongside other trade finance tools

Letters of credit are often used alongside other trade finance instruments as part of a broader working capital and risk management strategy, including supply chain finance programmes that help extend payment terms without straining supplier relationships, and receivables finance tools such as factoring and invoice discounting, which allow a seller to access cash tied up in outstanding invoices before the buyer actually pays. Understanding how these tools complement each other, rather than treating letters of credit as a standalone solution, is important for finance professionals structuring working capital strategy for businesses with significant international trade exposure.