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May 15, 2026

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Letter of Credit: Types, Process & Benefits

Letter of Credit: Processes, Types and Benefits

Understanding the Letter of Credit

Trust propels world trade. You, as a buyer from country A purchasing from someone in country B, are exposed to loss: the seller, should you not pay, and you, should you not receive goods. That's where a Letter of Credit comes in as a trusted financial bridge. The Letter of Credit, or LOC, is a document issued by the bank guaranteeing payment to the vendor upon fulfilment of contract conditions. It ensures payment and adherence to trade terms, facilitating smooth EXIM dealings under varied legal, financial, and political circumstances. LCs of India are subject to:

1. The Uniform Customs and Practice for Documentary Credits - An international standard standardising Letter of Credit terms.

2. The Indian Contract Act, 1872 and the Negotiable Instruments Act, 1881- ensure that the Letter of Credit contracts are legally enforced.

Importance of LCs to businesses

Risk Type	Challenge	How LC Helps
Payment Risk	The seller may ship goods, but not get paid	LC guarantees payment once the documents comply
Delivery Risk	Buyer pays, but the goods are not shipped	LC ensures the bank releases payment only upon proof of shipment
Credit Risk	Buyer or seller may default	The bank acts as a neutral third-party guarantor
Cross-border Transactions	Legal systems and currencies differ	Standardised LC terms reduce misunderstandings and disputes

What is a Letter of Credit (LC)?

It is the buyer's payment guarantee to the seller, issued by the bank, so the latter receives payment upon submitting delivery documents according to the contract. LCs are critical to both exporters and importers since they help eliminate payment defaults, legal disparities, and exchange rate risks.

"We'll pay once you furnish us the merchandise and proper documents," the buyer's bank assures the seller.

Major parties of a Letter of Credit

Term	Role	Function
Applicant	Buyer / Importer	Request an LC from the bank to ensure seller payment
Beneficiary	Seller / Exporter	Receives payment under LC terms
Issuing Bank	Buyer’s Bank	Issues LC, examines compliance, guarantees payment
Advising Bank	Seller’s Bank	Confirms the authenticity of LC, informs the seller
Confirming Bank	Secondary Bank	Guarantees payment if the issuing bank defaults
Negotiating Bank	Bank handling payment	Checks documents, releases payment
Reimbursing Bank	Settlement Bank	Settles payment between banks

Why businesses Use LCs

Guarantees payment in good faith for exporters.
Reduces credit and default risk.
Gains the confidence of foreign trading partners.
Guarantees bank funding and financing to the exporters.

Combinations of Letters of Credit (LCs)

Not all LCs are equal. LCs are selected by businesses according to purpose, flexibility, and payment guarantee. Importers and exporters should be well aware of these types to eliminate risks and make trade flow smoothly.

Type of LCs

Type of LC	Description	Use Case / Example	Key Advantage
Revocable LC	Can be altered or cancelled by the buyer without the seller’s consent	Rarely used today; buyer can change terms mid-trade	Flexible for the buyer but risky for the seller
Irrevocable LC	Cannot be modified/cancelled without the consent of both parties	Most international trade transactions	Secure, reliable payment for the seller
Confirmed LC	A second bank (confirming bank) guarantees payment if the issuing bank defaults	High-risk countries or banks	Extra security for the exporter
Unconfirmed LC	Only issuing bank guarantees payment	Stable countries with reliable banks	Simple and cost-effective
Sight LC	Payment is made immediately upon presentation of compliant documents	Fast shipments, immediate cash flow	Quick access to funds
Usance / Deferred LC	Payment made after a specified credit period (such as 30/60/90 days)	Credit-term transactions	Buyer gets extra time to pay
Transferable LC	The beneficiary can transfer the LC (partially/fully) to another party	Intermediary suppliers or subcontractors	Flexibility in supply chains
Back-to-Back LC	LC issued by the seller’s bank using a master LC as security	Resellers needing LC to pay manufacturers	Supports multi-level trade
Standby LC (SBLC)	Functions like a bank guarantee; used if the buyer fails to pay or perform	Large-scale contracts or high-risk clients	Risk mitigation and performance guarantee

Issuing a Letter of Credit (LC)

The LC procedure is indispensable to safe world trade. It ensures payment at contract execution, providing transparency and confidence for the buyer and the seller.

LC procedure steps

Step	Action	Key Notes / Example
1	Sales Contract Signed	Buyer and seller agree on trade terms requiring an LC. Example: ABC Exports agrees to sell machinery to Global Imports LLC.
2	Buyer Requests LC	The buyer applies to their bank (issuing bank) to issue an LC in favour of the seller. Bank checks creditworthiness.
3	Issuing Bank Sends LC	The issuing bank sends the LC via SWIFT to the seller’s advising bank, confirming the terms.
4	Seller Ships Goods	Seller dispatches goods as per the contract and collects required documents (such as invoice, BL, insurance, certificate of origin).
5	Documents Submitted	Seller submits documents to the negotiating bank for verification.
6	Document Examination	Bank checks documents against LC terms; minor discrepancies can delay or block payment.
7	Payment Released	Payment made according to LC type (sight or usance). Funds credited to the seller’s account.
8	Buyer Repays Issuing Bank	Buyer reimburses the bank per the agreed terms. LC transaction completes.

Documents required under a Letter of Credit (LC)

Proper submission of documents is required for LC compliance. Payments are only made by the bank if the documents are according to the LC terms. Faulty documents may cause the payment to be delayed or stopped, making it important for exporters to double-check every item.

Crucial documents and purpose

Document Category	Examples	Purpose / Notes
Commercial Documents	Packing List, Invoice, Certificate of Origin	Proves the sale, product details, and origin of goods. Essential for customs and trade compliance.
Transport Documents	Bill of Lading (B/L), Airway Bill, Road Consignment Note	Confirms shipment of goods. Banks check these before releasing payment.
Insurance Documents	Insurance Policy / Certificate covering transit risk	Protects the buyer/seller from loss or damage during transit. Often mandatory in LCs.
Inspection / Quality Certificates	SGS, Bureau Veritas, or government-authorised agency certificates	Confirms quality, quantity, or conformity with the contract. Important for regulated goods.
Regulatory Documents/ Customs	Shipping Bill, Export Declaration, Importer Exporter Code (IEC) Copy	Required for legal export/import compliance and customs clearance.

How the Letter of Credit works

LCs are explained better through an example. We shall diagram the procedure of the average international trade transaction.

Scenario:

Salesperson: ABC Exports Ltd., India
Buyer: Global Imports LLC, UK
Goods: Industrial equipment for ₹50L
Type of LC: Sight, Irrevocable.
Banks participating:
Bank: Barclays (UK)
Bank Advisor/Negotiator: HDFC

Process description

Step	Action	Parties Involved	Key Notes
1	Buyer requests LC	Global Imports → Barclays	Buyer applies for an LC specifying shipment, documents, and payment terms
2	The issuing bank sends the LC	Barclays → HDFC Bank	Advising bank confirms LC authenticity
3	Seller ships goods	ABC Exports → Buyer	Goods shipped as per contract; documents collected
4	Documents submitted	ABC → HDFC Bank	Invoice, Bill of Lading, Insurance and Certificate of Origin
5	Document examination	HDFC Bank	The bank verifies documents against the LC terms
6	Payment released	HDFC → ABC Exports	Once documents match, funds are credited to the seller
7	The buyer reimburses the bank	Global Imports → Barclays	Transaction completed per agreement

Benefits of a Letter of Credit

It benefits the importer and the exporter by reducing risk and ensuring smooth cash flow and financing.

Advantages chart

For Exporters (Sellers)	For Importers (Purchaser)	Key Points
Assured payment on compliance	Assurance that goods shipped per contract	Eliminates payment and default risk
Easier bank financing/working capital	Banks ensure the seller ships goods	Enables smooth trade financing
Reduced credit risk	Builds trust with international suppliers	Promotes reliable trade relationships
Faster cash flow through negotiation	Strengthens supplier relationships	Helps maintain inventory and operational continuity
Enhanced global credibility	Reduces the need for prepayment	Improves reputation for future deals

Why businesses engage LCs

Exporters (Sellers)

Payment is safe once all LC terms are fulfilled.
Ensures bank and trade finance since banks use LC as collateral.
Reduces the payment collection burden for overseas customers.

Importers (Buyers)

Payment is due upon delivery, in accordance with the agreed-upon quality and quantity. It gives us control of the transaction.
It supports long-term, low-risk relationships with suppliers.
An exporter of cloth selling to Europe may be settled on any legal backdrop of the buyer.

Participating banks in LC transfers

Banks are essential for Letter of Credit operations, acting as guarantors and document examiners to protect both seller and buyer. Their roles are crucial for successful LC implementation.

Types of banks and functions

Bank Type	Function in LC Transaction	SEO Keywords Integration
Issuing Bank	Issues LC on behalf of the buyer; ensures payment to the seller after compliance	Issuing bank in the LC process, LC issuing bank in India
Advising Bank	Confirms authenticity of LC; informs seller of terms	advising bank role in LC, LC advising bank India
Confirming Bank	Adds a guarantee of payment if the issuing bank defaults	confirmed LC bank, LC confirmation benefits
Negotiating Bank	Verifies documents, releases payment to the seller	LC document negotiation, negotiating with Bank India
Reimbursing Bank	Settles funds between issuing and negotiating banks	Reimbursing bank LC, LC fund settlement

Limitations and risks of Letters of Credit

Letters of Credit (LCs) are protective payment mechanisms of trade, but risks are present. Remaining vigilant prevents exporters and importers from having problems.

Risks and limitations

Risk Type	Explanation	Practical Example
Documentary Risk	Payment can be delayed or refused due to minor errors in documents	The wrong invoice date leads to the bank rejecting the LC payment
Bank Risk	An issuing or confirming bank may default or face financial instability	Exporter relying on a bank in a high-risk country
Country Risk	Payment may be blocked due to political instability, currency restrictions, or sanctions	The importer’s country imposes a currency freeze; the LC cannot be honoured
Cost Factor	LC fees, SWIFT charges, amendment costs, and negotiation fees add to trade expenses	A small exporter may face high bank charges
Time Delays	Verification and document checks may slow down payment	Multi-bank document processing delays cash flow

Letter of Credit vs Bank Guarantee

The Letter of Credit and the Bank Guarantees are employed for different but specific purposes of trade and contract execution. Understanding these applications ensures the choice of the proper financial instrument by the company.

Comparison chart

Basis	Letter of Credit (LC)	Bank Guarantee (BG)
Nature	Payment assurance	Performance or financial assurance
Purpose	Ensures payment to the seller/exporter	Ensures contract fulfilment or performance
Activation	Automatically upon document compliance	Activated only if the buyer defaults or the contract is not performed
Parties Involved	Applicant (buyer), Beneficiary (seller), Issuing & Advising Banks	Applicant (party requesting guarantee), Beneficiary, Issuing Bank
Risk for Beneficiary	Very low; the bank pays once the documents comply	Moderate; depends on the enforcement of the guarantee
Usage	Export-import transactions, trade payments	Contracts, tenders, performance bonds

Best practices

Proper planning, documentation, and banking cooperation are the keys to ensuring that a Letter of Credit (LC) is utilised efficiently. Smooth international trade, timely payments, and minimised risks are guaranteed through best practices.

Best practices table

Practice	Description	Practical Tip
Read the LC Terms Carefully	Understand every condition before shipment or production	Check shipment dates, partial shipment clauses, and payment terms
Use Standard Formats	Align with UCP 600 and banking norms	Standardised invoice, BL, and insurance formats reduce discrepancies
Ensure Document Accuracy	Verify names, numbers, dates, and Incoterms	Minor errors can delay or block payment
Consult Your Bank	Discuss confirmation, negotiation, or reimbursement facilities	Banks can guide on securing payments in high-risk countries
Maintain Digital Records	Keep scanned copies for reference and compliance	Helps with GST, export incentives, and audits
Review LC Expiry & Shipment Dates	Avoid rejection due to delays	Align production and shipment timelines with the LC expiry
Track Amendments	Monitor SWIFT messages and bank advisories	Ensure any LC modifications are acknowledged and approved

Conclusion

Letters of Credit, or LCs, are important in facilitating international as well as inland commerce. They eliminate credit risk and create confidence by assuring payment to the exporter and verifying compliance with shipments.

Major Points

Risk Mitigation:

LCs protect exporters from non-payment risks.
Buyers ensure shipment of merchandise per contract terms.

Bank Role Matters:

Issuing, advising, confirming, negotiating, and reimbursing banks form a chain providing safety and compliance of payment.

Document Accuracy is Crucial:

Variations can delay or block payments, making accurate verification essential.

Complex Trade Modes:

The LC types (sight, usance, confirmed, transferable, back-to-back) allow firms to make security and financing match the needs of the transactions.

Foreign Trade Credibility:

LCs give the firm increased foreign credibility so that larger contracts and better funding become feasible.

Tip: Businesses often issue letters of credit to secure international transactions, similar to how a credit note adjusts domestic billing errors. To learn more about credit notes and their conditional nature under Section 34 of the CGST Act, read our blogs here:

FAQs

Q1. What is the full form of LC

Answer: LC means Letter of Credit, a bank instrument that confirms payment by a buyer's bank to a seller upon completion of contractual obligations.

Q2. Who issues a Letter of Credit?

Answer: The issuing bank issues the LC upon the buyer's application and creditworthiness.

Q3. Is an export letter of credit required?

Answer: LCs are not compulsorily required by law, but they are highly recommended for new, high-value, or import/export transactions to eliminate payment risk.

Q4. How does the LC for sight differ from the usance LC?

Answer: Sight LC: Payment upon document verification.

Usance LC: Payable after a fixed credit period (30–90 days), by virtue of buyer convenience.

Q5. If the LC documents are not compliant?

Answer: Discrepancies within documents would cause payments to be stalled or declined by banks. Sellers would have to rectify or get buyer approval to make progress.

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