A Letter of Credit is a payment method where documents replace trust. We examine step by step how it works, its cost, and in which situations it is truly necessary.
In foreign trade, payment methods are ranked according to the risk balance between seller and buyer. Advance payment fully protects the seller, while cash against documents protects the buyer. A Letter of Credit is a middle ground between these extremes, shifting the risk to banks.
How does a Letter of Credit work?
The buyer requests their bank to issue a Letter of Credit in favor of the seller. The bank commits to make payment once the stipulated documents are presented complete. The seller ships the goods and submits the documents to their bank; if the documents are found compliant, payment is effected. Banks examine only the documents, not the goods.
In a Letter of Credit, the bank's obligation is to the document, not the goods. This single sentence explains both the strength and the weakness of a Letter of Credit.
The most critical point: document discipline
The most common issue in Letter of Credit transactions is minor inconsistencies in the documents. A product description on the invoice that does not match the Letter of Credit wording exactly, a bill of lading date that exceeds the shipment period, or a missing signature are enough for the bank to place a reservation. A reservation means the payment is halted and left to the buyer's discretion.
What is the cost?
A Letter of Credit is not a free guarantee. When opening commissions, notice, confirmation and document examination fees are added, a significant cost is imposed on top of the transaction amount. The contract must clearly state who will bear this cost.
When is it worth using?
It is worth the Letter of Credit cost when dealing with a new client, selling to a country with high political or economic risk, for products with long production times and custom preparation, or when the transaction amount exceeds the loss the company can absorb. With long‑standing clients who have a clean payment history, cash against documents is both faster and cheaper.
Letter of Credit practices and case studies, together with credit insurance applications, are included in ITSL's specialist curriculum.