What is a letter of credit?

If you trade across borders, you need a way to guarantee payment without fully trusting a stranger. A letter of credit, also called a letter of undertaking, is a bank-issued promise that a seller gets paid once they meet agreed conditions. The bank checks all documentation, then releases funds, giving both buyer and seller confidence the deal will close.

A letter of credit is a useful tool for mitigating risk in business transactions where the parties may not have worked with one another previously or do not operate under common regulations and customs.

Using a letter of credit in export and shipping


When goods cross borders, timing matters. An export letter of credit ties payment directly to proof of shipment, so both sides know exactly when funds will move.


Here's how it typically plays out for each party:

For importers (buyers):

• Demonstrates you're serious and financially capable, which helps seal the deal
• Confirms you won't pay until shipment is verified
• Frees up working capital by removing the need for advance deposits
  
  For exporters (sellers):
  
  
• Guarantees payment once goods are shipped and documents are in order
• If the buyer's issuing bank fails to pay, the bank itself covers the amount due
• Can serve as collateral for short-term loans, useful when liquidity is tight and borrowing options are limited
• This structure keeps shipments moving without either party carrying the full weight of the risk.
  
  Why is a letter of credit required in international trade?
• International transactions often involve partners who've never worked together, operate under different legal systems, or sit thousands of miles apart. That combination naturally raises the stakes.
• An import LC bridges that gap. It gives the buyer's bank a formal role in the deal, so the seller isn't relying purely on trust or reputation. This matters most when:
• You're dealing with a new supplier for the first time
• Local laws or payment customs differ significantly between countries
• Political or economic instability makes non-payment more likely
• The transaction value is large enough that a default would hurt
  
  In these higher-risk situations, a letter of credit does the heavy lifting that a simple invoice or purchase order can't. It shifts payment assurance away from personal trust and onto a regulated banking relationship, which is exactly what businesses need when expanding into unfamiliar markets.

Not all letters of credit work the same way. Depending on your trade relationship, timeline, and risk appetite, one type will suit your deal far better than another. Here's a quick look at the most common LCs, followed by a closer look at each one

Commercial (documentary) letter of credit

Also called a documentary credit (DC) or import/export letter of credit, this is the most widely used type. A bank acts as a neutral third party, paying the beneficiary directly once every contractual condition has been satisfied. You'll typically see it used for single, one-off transactions rather than ongoing trade relationships.

Revolving letter of credit

Got a partner you work with again and again? A revolving letter of credit might save you the hassle of arranging a new one every time. Unlike a standard commercial LC, it covers multiple transactions, or several phases of one large project, over a set period, often one to three years.

Confirmed letter of credit (confirmation)

A confirmed letter of credit adds a second guarantee from another bank, usually one the seller already knows and trusts in their home country. If the issuing bank fails to pay once terms are met, the confirming bank steps in to cover it, then recovers the funds from the issuing bank. This structure builds confidence between buyers and sellers who don't have much shared history.

Traveler's letter of credit

Heading abroad for business? A traveler's letter of credit lets you withdraw funds from correspondent banks in other countries instead of a single named beneficiary. Backed by the issuing bank's credit, it saves you from carrying large sums of cash and paying steep foreign exchange fees along the way.

Standby letter of credit

Most letters of credit guarantee payment happens on schedule. A standby letter of credit (SBLC) flips that logic: it only pays out if the buyer defaults. Because most standby LCs never get triggered, the paperwork and process tend to be lighter than other types.

Irrevocable letter of credit

These days, most letters of credit are irrevocable by default. That means no one can change the terms without sign-off from every party involved: buyer, seller, and bank alike. It's a simple feature, but it gives both sides real assurance the deal won't shift underneath them.

Red clause letter of credit

Need cash before you ship the goods? A red clause letter of credit lets the buyer extend an unsecured advance to the seller, often as a percentage of the total value, so the seller can cover materials and production costs upfront. That advance is later deducted as a credit against the final invoice. It's a useful workaround compared to seeking a separate loan.

Deferred payment (usance) letter of credit

Also known as a term or usance letter of credit, this version delays payment to the seller until an agreed date after shipment. Why would a buyer want this? It gives them time to confirm the goods meet expectations, or even to resell them before settling the invoice. It's a buyer-friendly structure, so expect sellers to negotiate the terms carefully.

Sight letter of credit

Here, payment happens as soon as the beneficiary submits the required documents and the bank approves them. There's no waiting period like you'd find with deferred payment or usance versions. As one of the more straightforward negotiable instruments in trade finance, it's a good fit when speed matters more than flexibility.

Back-to-back letter of credit

This one involves more moving parts: an issuing bank, an applicant, a beneficiary, an intermediary, and two separate letters of credit. The buyer secures one LC to pay the intermediary, who then secures a second LC to pay the actual seller. It's commonly used to guarantee payments across supply chains involving suppliers, subcontractors, or sales agents.

Transferable letter of credit

A transferable letter of credit lets the original beneficiary pass on some or all of their payment rights to a second beneficiary, often a supplier or broker further up the chain. Unlike a back-to-back arrangement, there's only one letter of credit involved, just with more than one party able to draw on it. This makes it a practical option when intermediaries need flexibility without the cost of arranging separate agreements.

A letter of credit only works because several parties, each with a clearly defined role, follow the same rulebook. That rulebook comes from the International Chamber of Commerce (ICC), whose Uniform Customs and Practice for Documentary Credits (UCP 600) sets the standard that banks worldwide use to interpret letters of credit consistently. Knowing who's who helps you understand where risk sits and who to contact when questions come up.

Here's a quick reference table before we break down each role in more detail:

Applicant

The applicant is the buyer who asks their bank to issue the letter of credit. They're the one putting up collateral or a credit line to get the process started.

Beneficiary

The beneficiary is the seller. Once they've met every condition spelled out in the letter of credit, they're the party who gets paid.

Issuing bank

Sometimes called the opening bank, the issuing bank creates the letter of credit at the applicant's request. In most cases, it also makes the direct payment to the beneficiary once conditions are satisfied.

Advising bank in a letter of credit

An advising bank sits on the seller's side of the transaction. It authenticates the letter of credit and passes it along to the beneficiary, confirming that the document is genuine. In cross-border deals, you'll usually find the advising bank located in the beneficiary's home country, which makes communication and document handling far more straightforward.

Confirming bank

For confirmed letters of credit, the confirming bank steps in with an additional guarantee. If the issuing bank fails to pay once terms are met, the confirming bank covers the amount and then seeks reimbursement itself. This extra layer builds trust when buyer and seller don't have an established relationship.

Negotiating bank and negotiation

The negotiating bank handles the beneficiary's submitted documents and checks them against the letter of credit's terms. Negotiation here means the bank may advance funds to the beneficiary before recovering that amount from a reimbursing bank, speeding up cash flow for the seller while the formal claims process runs in the background.

Reimbursing bank

The reimbursing bank holds the account the issuing bank uses for settlement and honors reimbursement claims submitted by the negotiating bank.

Secondary beneficiary

A secondary beneficiary, sometimes called a transferee, is a party such as a corporate parent or broker to whom the original beneficiary transfers all or part of the letter of credit's value

A letter of credit brings the buyer's bank, the seller, and often a second bank together to guarantee payment. Once you understand the sequence, the process is actually pretty straightforward, even though the paperwork can feel intimidating at first.

The letter of credit process step by step:

Here's how a typical transaction moves from request to payment:

1. Application: The buyer (applicant) asks their bank to issue a letter of credit, based on the terms already agreed in the sales contract.
2. Issuance: The issuing bank reviews the applicant's creditworthiness, sets any required collateral or fees, and issues the letter of credit.
3. Advising: The letter of credit is sent to the seller's bank (the advising bank), which confirms its authenticity to the beneficiary.
4. Shipment: The seller ships the goods and gathers the documents proving the terms were met, such as invoices and bills of lading.
5. Document presentation: The seller submits these documents to the bank within the agreed timeframe.
6. Verification and payment: The bank checks the documents against the letter of credit conditions. If everything matches, payment is released to the seller.
    

Letter of credit payment terms

Not all letters of credit pay out the same way, and the timing matters a lot for both sides.

• Sight: Payment happens as soon as the beneficiary submits compliant documents and the bank reviews them, often within a few business.
  

Deferred (or usance): Payment is delayed until a specified date, commonly 30, 60, or 90 days after shipment or invoice.

Sight terms suit sellers who want fast cash. Deferred terms give buyers breathing room to inspect or resell goods before paying. Your choice should reflect how much risk each party is willing to carry.

Governing rules: UCP 600

Letters of credit don't operate on their own. Most are governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), a rulebook published by the International Chamber of Commerce.

First introduced in 1933 and last revised in 2007, UCP 600 spells out how banks should examine documents, handle discrepancies, and process claims. It's why banks pay against paperwork, not against the physical goods themselves. If the documents don't match the letter of credit terms exactly, payment can be delayed or refused, so precision matters at every step

Getting a letter of credit starts with your bank and a solid sales contract. You'll need to prove you can pay, agree on terms with your trading partner, and cover the bank's fees before the document is issued. Here's exactly how that plays out, step by step.

1. Check the buyer's creditworthiness. Before anything else, the bank reviews the applicant's financial standing to decide whether it's willing to back the deal.
   
   
2. Agree on LC terms in the sales contract. Both parties need to spell out payment conditions, shipment dates, and required documentation directly in the contract.
   
   
3. Apply through the issuing bank. The buyer submits a formal application, usually through a bank they already have a relationship with.
   
   
4. Pledge collateral or secure a credit line. Most banks ask for cash collateral or an existing credit facility to offset their risk.
   
   
5. Pay the required fees. These cover issuance and any additional services the bank provides.
   
   
6. Wait for the bank to issue the LC. Once approved, the letter of credit is sent to the seller's bank, and the transaction can move forward.
   
   The whole process typically takes a few business days, though it can stretch longer if your documentation isn't complete or your creditworthiness needs closer review.

Letter of credit costs and fees

Letters of credit aren't free, and the costs can add up quickly if you're not prepared. Fees generally fall into four categories: issuance (or opening), confirmation, advising, and amendment.

The issuance fee, charged by the applicant's bank, usually runs around 0.75% of the credit amount, though it can climb higher depending on transaction size, country risk, and how creditworthy the buyer looks on paper. Confirmation fees apply only when a second bank guarantees the deal, adding extra security but also extra cost. Advising fees are typically smaller and cover the work the seller's bank does to verify authenticity and pass along the terms. Amendment fees kick in any time the contract terms change after the LC has been issued, so it pays to get everything right the first time.

Most of these charges land on the buyer's side, since they're the ones requesting the guarantee. Sellers may still cover smaller costs, like advising or document handling, through their own bank

What documents are needed for a letter of credit?

Payment under a letter of credit doesn't happen automatically once goods ship. It's released only when you present documents that match the letter of credit's terms exactly. Even a small discrepancy, like a misspelled company name or a shipping date that's off by a day, can delay payment or give the bank grounds to refuse it. That's why getting the paperwork right matters just as much as fulfilling the actual order.

Here are the documents you'll typically need to submit:

How to avoid costly letter of credit discrepancies

Getting documents right the first time protects your cash flow and prevents costly delays in cross-border trade. Banks examine paperwork under UCP 600, the rulebook that governs how documentary credits are checked, and they apply it with strict compliance. When your documentation shows conflicting details, even something minor, the issuing bank can halt payment until it's resolved.

Want to keep discrepancies to a minimum? Follow these steps:

• Conduct a pre-submission review. Compare the letter of credit against your commercial invoice, bill of lading, and packing list to confirm every data point matches perfectly.
• Verify crucial dates. Make sure shipment happens before the latest shipment date, and submit your papers well ahead of the expiry timeline set in the credit.
• Standardise party descriptions. Use exact corporate legal names and addresses for both applicant and beneficiary. No typos, no unauthorized abbreviations.
• Eliminate ambiguous wording. Skip vague terms like "prompt" or "immediately." Set concrete calendar dates and defined shipment milestones instead.
• Review financing terms. Confirm the invoice balance doesn't exceed the total credit amount authorized by the issuing bank.

Here's the thing: under UCP 600, banks examine documents on their face value, not the actual condition of the goods. That means a single mismatched detail, even if the shipment itself is perfectly fine, can trigger a payment delay or outright refusal.

Aligning your paperwork with precision safeguards the transaction, minimizes payment risk, and helps banks disburse funds smoothly, without back-and-forth disputes eating into your timeline.

Weighing the pros and cons upfront saves you from surprises once the paperwork is signed. Here's what to consider before you commit to a letter of credit for your next deal.

Key advantages for buyers and sellers

A letter of credit earns its place in international trade because it solves a real problem: trust between parties who don't know each other well.

• Payment security: The seller knows funds will arrive once contractual obligations are met, regardless of the buyer's personal reputation.
• Trust between unfamiliar partners: A bank's involvement replaces guesswork with a regulated guarantee, useful when you're dealing with a new supplier or market.
• Cash-flow benefits: Buyers avoid tying up capital in advance deposits, while sellers get paid faster than they would waiting on open account terms.
• Collateral value: Sellers can use a confirmed letter of credit as collateral for short-term loans, helpful when liquidity is tight.
• Conditional clarity: Every requirement is spelled out in writing, so both sides know exactly what triggers payment and what doesn't.
  
  Disadvantages and limitations to weigh
  
  
• No instrument is perfect, and letters of credit come with real trade-offs worth considering.
• Cost: Issuance, confirmation, advising, and amendment fees add up, and most of that burden falls on the buyer's side.
• Complexity: Multiple banks, strict documentation, and formal procedures mean more moving parts than a simple invoice.
• Rigidity: Once issued, terms are hard to change. Even a standby letter of credit, meant as a backup safeguard, still requires careful drafting upfront.
• Strict compliance: Banks pay against documents, not goods. A minor discrepancy, like a misspelled name, can delay or block payment entirely.
• Dispute resolution: If something goes wrong, resolving it may involve courts rather than a quick conversation between trading partners.
   

Banker's guarantee vs letter of credit: which is better?

Neither instrument is universally "better." A letter of credit and a banker's guarantee protect you against different risks, and picking the right one depends on what could go wrong in your deal.

How a banker's guarantee differs

A letter of credit is proactive: the bank pays once the seller meets agreed delivery conditions, regardless of whether the buyer runs into trouble later. A banker's guarantee works the opposite way. It's reactive, sitting quietly in the background and only paying out if one party fails to meet its contractual obligations, like defaulting on a payment or missing a project deadline.

That difference shapes cost, too. Where letter of credit fees typically run around 0.75% of the credit value, banker's guarantee fees usually range from 0.5% to 3% annually, depending on the risk profile and how long the guarantee stays active. You're essentially paying for protection against a default that may never happen, similar to an insurance premium rather than a transaction fee.

When to choose each option

Ask yourself what you're actually trying to prevent. If you need guaranteed payment tied to specific delivery milestones, like shipment or document handover, a letter of credit fits better. If you need reassurance that a contract will be honored over time, such as a construction project or long-term supply agreement, a banker's guarantee makes more sense.

• Choose a letter of credit for one-off trade deals where payment should happen automatically once goods or documents are verified.
• Choose a banker's guarantee for ongoing contracts where the real risk is non-performance or default rather than a single payment event.
• Consider both when a deal involves upfront payment terms and long-term performance obligations. Financial institutions can often structure them together.

Letters of credit work well for single shipments, but they're not the only way to protect your business from non-payment. If you're trading regularly with multiple buyers, there's a more flexible option worth knowing about.

Why businesses look beyond letters of credit

Here's the thing about letters of credit: they're built for one transaction at a time. Need to ship to five different customers this month? That's potentially five separate letters of credit, each with its own fees and paperwork.

That adds up fast. Beyond the issuance costs, letters of credit tie up your buyer's credit lines with their bank, which can limit how much they're able to purchase from you. For growing companies juggling several trading partners, this becomes a real bottleneck.

There's also the complexity factor. Every shipment means renegotiating terms, checking documents against strict conditions, and hoping nothing gets flagged as a discrepancy. In fast-moving international trade, that kind of friction can slow down deals that should otherwise close quickly.
 

How trade credit insurance protects your cash flow

Trade credit insurance takes a different approach. Instead of securing one deal at a time, it covers your entire portfolio of customers and transactions over a set period, often a full year.

That shift changes how you think about risk. Rather than arranging a new letter of credit every time you sell, you get ongoing protection against the risk of non-payment across your whole customer base. Whether a buyer defaults, becomes insolvent, or delays payment beyond agreed terms, your policy steps in to cover the loss.

This matters most when you're expanding sales. Want to offer open account terms to a new customer in an unfamiliar market? Trade credit insurance gives you the confidence to do that without demanding upfront payment or arranging a fresh trade finance instrument every time.

It also strengthens your accounts receivable as an asset. Insured receivables are viewed more favorably by lenders, which can improve your access to financing down the line. For businesses selling internationally to dozens, or even hundreds, of buyers, that's a far more practical safety net than juggling individual letters of credit.

Curious how this could work for your business? Speak with an Allianz Trade expert to see how trade credit insurance can protect your receivables and support your growth.

Who gives a letter of credit?

The buyer's bank gives a letter of credit. Known as the issuing bank, it creates the document at the applicant's request once it's satisfied the buyer can pay. This bank then commits to paying the seller directly, provided every condition in the letter of credit is met.

What is a letter of credit and how does it work?

A letter of credit, also called a documentary credit, is a bank-issued guarantee that a seller gets paid once agreed conditions are met. It works on a document-against-payment basis: the seller ships the goods, submits paperwork like invoices and bills of lading, and the bank releases funds only once those documents match the letter of credit's terms exactly.

When is a letter of credit issued?

A letter of credit gets issued after the buyer and seller sign their sales agreement and settle on payment terms. From there, the buyer applies through their bank, which reviews their creditworthiness and any collateral on offer before issuing the document. Only once that review clears does the letter of credit move forward to the seller's bank.

What is letter of credit discounting?

Letter of credit discounting lets a seller get paid early against an accepted usance letter of credit, rather than waiting for the full deferred payment date. The seller's bank advances the funds now, minus a discount fee, then collects the full amount from the issuing bank once it falls due. It's a handy way to free up cash flow without waiting out the full payment term, and it works differently from a standby letter of credit, which only pays out if the buyer defaults.

What does a letter of credit look like?

A letter of credit is a formal bank document that spells out every party involved (applicant, beneficiary, issuing bank), along with the credit amount, shipment conditions, required documents, and expiry date. It follows strict formatting rules set out in UCP 600, so banks worldwide can read and verify it the same way. These days, most letters of credit exist in electronic form rather than paper, though the core structure stays the same regardless of format.