What is a letter of credit? Meaning and how LC payment works

For an exporter, a letter of credit can be both the strongest payment safeguard and the most treacherous trap. At heart it is simple: the buyer's bank undertakes to pay when the documents named in the letter of credit are presented in line with the rules. Payment then rests not on the buyer's goodwill but on a bank's conditional undertaking.

This guide explains what a letter of credit is, how it works step by step, who the parties are and which types exist — and, most importantly, where the exporter is protected and where they get caught out.

What exactly is a letter of credit?

A letter of credit is a conditional, usually irrevocable undertaking to pay given by the issuing bank (the buyer's bank). The condition is this: the bank pays if the documents the text calls for are presented within the stated period and in line with UCP 600. If the documents are off by even a word — a discrepancy — the bank can withhold payment. That is why, with a letter of credit, the real work is on paper, not in the goods.

Who does what? The parties to a letter of credit

• Issuing bankUCP 600 Art. 7

  The buyer's bank. It opens the letter of credit and gives the conditional undertaking to pay.

• Advising bankUCP 600 Art. 9

  Advises the letter of credit to the beneficiary and checks that it is authentic.

• Confirming bankUCP 600 Art. 8

  Adds a second, independent undertaking to pay. Optional, but critical in a high-risk market.

• BeneficiaryUCP 600 Art. 2

  The exporter. Presents the documents and receives payment.

How does it work, step by step?

1. 1
   Sales contract

   Buyer and seller agree on a letter of credit as the payment method. The goods description, delivery terms (Incoterms), payment terms and required documents are settled here.

2. 2
   LC draft / application

   The buyer passes the letter of credit text to its bank. This is exactly where it becomes clear whether the text works for the exporter or against them — and the only moment when fixing it is cheap.

3. 3
   Issuance

   The issuing bank opens the letter of credit over SWIFT and it reaches the beneficiary through the advising bank. If confirmation is required, whether it can actually be obtained must be settled at this stage.

4. 4
   Shipment

   The exporter ships the goods and prepares the document set the letter of credit calls for (commercial invoice, bill of lading, certificate of origin, insurance policy and so on).

5. 5
   Presentation

   The documents are presented to the bank. A single mismatch — a date, a word, a contradiction — means a discrepancy. This is the most fragile moment of the whole process.

6. 6
   Collection

   If the documents are clean, the bank pays: at sight or, for a deferred payment credit, at the agreed maturity. The deal closes when the money is in the account.

Steps two and five decide the exporter's outcome. Getting the text right is the job of an LC text review; zero discrepancies at presentation is the goal of document preparation and presentation follow-up.

Types of letter of credit (in brief)

• Irrevocable: Cannot be amended or cancelled without the parties' consent. This is the standard today.
• Confirmed: A second bank adds an independent undertaking to pay. It becomes critical when the issuing bank or its country is risky.
• Deferred payment / usance: Payment falls due a set number of days after presentation. Early payment is possible through discounting.
• Revolving: Renews automatically for repeat shipments, so it does not have to be reopened for each one.
• Red / green clause: Special clauses that let the beneficiary draw an advance before shipment.

In high-risk markets the most important distinction is confirmation; whether you need it is determined by a confirmation analysis.

For a full breakdown, see: Types of letters of credit

Why is it both a safeguard and a trap?

The safeguard is obvious: payment depends on a bank's undertaking, not on the buyer's goodwill. The trap is in the text. The bank is a referee — it will not correct the text in your favor, and if something is wrong it raises a discrepancy at presentation, by which point collection is already late. Most discrepancies come not from big mistakes but from small contradictions that could have been spotted before issuance. We walk through them with two real transactions in three silent risks in a letter of credit. Running the process end to end is the scope of end-to-end operational management.