How a letter of credit in international trade works for importers and exporters

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A letter of credit in international trade, also known as a documentary credit, is a bank undertaking to pay the exporter if the exporter presents documents that comply with the credit. It reduces the exporter’s exposure to buyer non-payment and gives the importer evidence that the seller has produced the required shipping or commercial documents before payment is released. Its main limitation is equally important: banks examine documents, not the physical goods. For that reason, the wording of the credit, the sales contract, transport terms, document list, expiry date and presentation rules often determine whether the transaction runs smoothly.

For more context on commercial paperwork, see our trade documentation resources.

What a letter of credit actually does

A commercial letter of credit addresses a common cross-border trade problem. The seller may be unwilling to ship goods to a distant buyer without reliable payment assurance. The buyer may be unwilling to pay in advance without evidence that the seller has shipped the goods or completed the required commercial steps. The issuing bank bridges that gap by promising to honor a complying presentation.

Under ICC terminology, the applicant is usually the importer or buyer, and the beneficiary is usually the exporter or seller. The issuing bank opens the credit at the applicant’s request. An advising bank authenticates and forwards the credit to the beneficiary. A nominated bank may receive documents and pay, accept, negotiate or forward the presentation, depending on the credit. If a confirming bank is added, that bank gives its own independent undertaking to honor a complying presentation.

This structure does not mean the bank guarantees that the goods are perfect, marketable or contractually satisfactory. U.S. banking guidance and ICC rules both emphasize the document-based nature of the instrument. If the documents comply on their face, the bank’s payment obligation may arise even if a commercial dispute later develops between buyer and seller. If the documents do not comply, the bank may refuse payment even where the goods themselves arrived in good condition.

The usual transaction flow

Exact procedures vary by bank and jurisdiction, but a typical commercial LC usually follows this sequence:

1. The importer and exporter agree on the sales contract, price, Incoterms rule, shipment period, required documents and payment method.
2. The importer applies to its bank for an LC and provides credit support, collateral or a facility as required by the bank.
3. The issuing bank issues the credit in favor of the exporter and sends it, often through an advising bank.
4. The exporter reviews the credit before shipment and requests amendments if the terms are impossible, unclear or inconsistent with the sale.
5. The exporter ships the goods and obtains the required documents, such as the commercial invoice, transport document, packing list, insurance document or certificate of origin.
6. The exporter or presenter submits documents to the nominated bank, confirming bank or issuing bank within the permitted period.
7. The examining bank determines whether the presentation appears to comply. If it complies, payment, acceptance, deferred payment or negotiation proceeds according to the credit.
8. The importer reimburses the issuing bank and receives documents needed to claim goods or clear customs.

The fourth step is often the most important for risk control. Exporters should not assume that an issued credit is automatically workable. A credit that demands documents the seller cannot obtain, uses the wrong shipment date, conflicts with the Incoterms rule or names the wrong port can create a discrepancy before the goods move.

Why UCP 600 and ISBP matter

Most international documentary credits are issued subject to the ICC’s Uniform Customs and Practice for Documentary Credits, commonly known as UCP 600. UCP 600 applies when the credit expressly states that it is subject to those rules. This is a practical drafting point: the rule set should be written into the LC, not merely assumed from the sales contract.

Several UCP 600 principles shape day-to-day LC operations. Article 2 defines a credit as an irrevocable arrangement and defines a complying presentation by reference to the credit terms, UCP provisions and international standard banking practice. Article 3 provides that a credit is irrevocable even if it does not expressly say so. Article 4 treats the credit as separate from the underlying sale contract. Article 5 states the core documentary principle: banks deal with documents rather than goods, services or performance.

Article 14 is especially important for document examination. It gives the relevant bank a maximum of five banking days following the day of presentation to determine whether the documents comply. This period is not a quality inspection window for goods; it is a document review window. Article 16 then deals with refusal, waiver and notice when documents are discrepant.

International Standard Banking Practice, currently reflected in ICC publication ISBP 821, is used to interpret how documents are examined under UCP 600. For example, it helps clarify how data should appear across invoices, transport documents, certificates and other papers. It does not replace the credit. If the LC itself is poorly drafted, ISBP cannot turn an impossible condition into a practical one.

Common LC types and how they compare

The term letter of credit can refer to several instruments. In ordinary merchandise trade, the most relevant distinction is often between a commercial documentary LC and a standby LC. A commercial documentary LC is the expected payment mechanism for a shipment. A standby LC normally works as a back-up payment or performance instrument, drawn when the applicant fails to perform an agreed obligation.

Instrument	Main purpose	Typical use	Key limitation
Commercial documentary LC	Primary payment method against compliant documents	New relationship, higher-risk buyer or higher-risk market	Payment depends on document compliance, not direct inspection of goods
Confirmed LC	Adds a second bank’s undertaking to the issuing bank’s undertaking	Exporter is concerned about issuing bank risk or country risk	Higher cost and subject to the confirming bank’s approval
Standby LC	Back-up assurance if the applicant defaults	Open account supported by a bank instrument, service contracts or performance obligations	Not usually the routine payment channel for each shipment
Documentary collection	Banks handle documents and payment instructions without issuing a payment undertaking	Established buyer relationship and moderate risk	Less protection for the exporter than an LC
Open account	Seller ships first and buyer pays later	Trusted buyer, competitive market or insured receivables	Higher non-payment exposure for the exporter

A confirmed LC can be useful where the exporter accepts the buyer but is less comfortable with the issuing bank or the political, transfer or currency conditions in the buyer’s country. The confirming bank is not merely passing messages; it adds its own independent undertaking, usually for a fee, and only after approving the credit and the issuing bank exposure.

Documents that usually decide payment

In LC transactions, document selection should be disciplined. A long document list may look safer to an importer, but every additional document adds discrepancy risk. ICC educational materials warn that documentary requirements should be limited to documents that are genuinely necessary for payment, shipment control, insurance, customs clearance or regulatory compliance.

Common documents include: See also: Customs and Compliance.

• Commercial invoice showing seller, buyer, goods description, price, currency and other required data.
• Transport document such as an ocean bill of lading, sea waybill, air waybill, road consignment note or multimodal transport document.
• Packing list detailing packages, weights, measurements and marks.
• Insurance document where the seller is responsible for insurance or the credit requires evidence of cover.
• Certificate of origin where customs, preferential tariff treatment or buyer requirements make origin evidence necessary.
• Inspection or quality certificate only where a reliable issuer, timing and content requirement are clearly defined.

The LC should avoid vague requirements such as acceptable quality certificate or shipment evidence satisfactory to buyer. Banks need objective document standards. If the importer wants technical acceptance rights, that requirement should be drafted carefully in the sales contract and reflected in a bankable document condition, such as a certificate issued by a named independent inspection company.

Drafting points importers and exporters should check

A workable LC begins before the application form reaches the bank. The sales contract should align with the LC on shipment period, latest shipment date, expiry date, partial shipments, transshipment, Incoterms rule, named port or place, insurance responsibility and document content. ICC guidance on Incoterms 2020 stresses that the chosen rule should include a named place or port and the year of the rules. That detail matters because an LC may require a transport document that does not match the agreed delivery structure.

For exporters

• Check whether the issuing bank and country risk are acceptable, or whether confirmation is needed.
• Review every document requirement before producing or shipping goods.
• Confirm that the latest shipment date, expiry date and presentation period are realistic.
• Make sure the goods description is not so narrow that minor invoice wording creates a discrepancy.
• Coordinate early with the freight forwarder, insurer, chamber of commerce and inspection body.

For importers

• Require only documents that are commercially useful and obtainable from reliable parties.
• Do not use the LC as a substitute for supplier due diligence, product inspection or contract remedies.
• Align the LC with customs requirements, import licenses and the Incoterms rule.
• Consider whether a sight payment, deferred payment or acceptance structure matches cash flow needs.
• Budget for bank fees, amendment fees, confirmation charges and possible discrepancy charges.

Both sides should treat amendments as controlled changes, not informal email corrections. Under UCP 600, a credit cannot be amended or cancelled without the required agreement of the relevant parties, including the beneficiary and, where applicable, the confirming bank.

Risk, cost and market context

A letter of credit reduces specific payment risks, but it does not remove all trade risk. On its own, it does not prove product quality, prevent fraud, guarantee customs clearance, eliminate sanctions exposure or solve foreign exchange risk. It can also increase cost and administrative workload. For low-risk repeat trade, open account supported by credit insurance, factoring or a standby LC may be more competitive. For first shipments, higher-value goods or markets with elevated payment risk, a documentary LC may still be justified.

Recent U.S. trade finance data also show why LCs are specialized rather than universal. A Federal Reserve note published on May 8, 2026 reported that, as of the fourth quarter of 2024, outstanding U.S. commercial letters of credit were about $15 billion in call report data, while trade finance loans in the Y-14 data totaled about $70 billion to foreign firms and $30 billion to U.S. firms. The same note observed that U.S. trade finance activity is concentrated among large banks and that many trade finance instruments are short-term, often maturing within 90 to 180 days.

The practical takeaway is that LCs are important where documentary control and bank risk substitution add value, but they are not automatically the right payment method for every shipment. The right choice depends on bargaining power, buyer credit, country risk, transaction value, product complexity, document reliability and the seller’s need for financing.

Frequently asked questions

Is a letter of credit the same as advance payment?

No. Under advance payment, the buyer pays before shipment, placing more performance risk on the buyer. Under a letter of credit, the bank pays or undertakes to pay when the exporter presents documents that comply with the credit.

Does a letter of credit guarantee the quality of goods?

No. A commercial LC is document-based. If the buyer needs quality assurance, the contract and LC should require a clearly defined inspection certificate or other reliable evidence, and the buyer should still conduct supplier and product due diligence.

What is the biggest cause of LC problems?

The most common practical problem is discrepancy risk: documents do not match the credit, conflict with one another, arrive late or are issued by the wrong party. Many discrepancies can be prevented by reviewing the draft LC before shipment.

When should an exporter ask for a confirmed LC?

Confirmation may be appropriate when the exporter is concerned about the issuing bank, political risk, transfer risk, currency restrictions or extended payment terms. The exporter should weigh the added protection against the cost and availability of confirmation.

Can the sales contract override the LC?

Not in the bank’s document examination. The credit is separate from the sales contract, and banks look to the LC terms and applicable rules. That is why the contract and LC should be aligned before goods are shipped.