Letter of credit (LC): the complete guide to documentary credits

What is a letter of credit?

A letter of credit (LC), also called a documentary credit (DC or DLC), is a written undertaking by a bank, issued at the request of a buyer, to pay a seller up to a stated amount, provided the seller presents the documents required by the credit within its deadlines.

Two principles make the instrument work. First, the credit is independent of the sales contract: the bank’s obligation depends on the documents, not on whether the buyer is satisfied with the goods. Second, banks deal with documents, not goods. They check that the documents presented comply on their face with the terms of the credit and with international standard banking practice.

The vast majority of LCs are issued subject to the ICC Uniform Customs and Practice for Documentary Credits, 2007 revision (UCP 600). Under UCP 600 a credit is irrevocable even if there is no indication to that effect: once issued, it cannot be cancelled or amended without the agreement of the issuing bank, any confirming bank and the beneficiary. Where documents are presented electronically, the eUCP supplement applies alongside UCP 600.

Who are the parties to a letter of credit?

• Applicant: the buyer or importer who asks its bank to issue the credit and who reimburses the bank.
• Beneficiary: the seller or exporter in whose favour the credit is issued.
• Issuing bank: the applicant’s bank, which gives the payment undertaking.
• Advising bank: a bank, usually in the beneficiary’s country, that checks the apparent authenticity of the credit and passes it on. Advising alone creates no obligation to pay.
• Confirming bank: a bank that adds its own undertaking to honour or negotiate, in addition to the issuing bank’s.
• Nominated bank: the bank with which the credit is available for payment, acceptance or negotiation.
• Reimbursing bank: in some credits, the bank instructed to reimburse the paying or negotiating bank.

How does a letter of credit work, step by step?

1. Buyer and seller agree in their contract that payment will be made by LC, and agree its main terms: amount, Incoterms® 2020 rule, latest shipment date, documents and expiry.
2. The buyer applies to its bank. The bank assesses the buyer’s credit and may require a credit line, collateral or a cash margin.
3. The issuing bank issues the credit, usually by SWIFT MT700 to an advising bank.
4. The advising bank advises the credit to the seller, adding its confirmation if requested and agreed.
5. The seller checks the credit, ships the goods and prepares the documents.
6. The seller presents the documents to the nominated or confirming bank before expiry.
7. The bank examines the documents. If they comply, it pays, accepts a draft, incurs a deferred payment undertaking or negotiates, depending on how the credit is available.
8. The documents travel to the issuing bank, which reimburses the nominated bank and releases the documents to the buyer against payment or under its credit facility. The buyer uses the transport document to collect the goods.

Example (illustrative): a distributor in Abidjan buys machinery from a manufacturer in Valencia. The parties agree an irrevocable LC, available by payment at sight, CIF Abidjan under Incoterms® 2020, requiring a full set of clean on-board bills of lading, a commercial invoice, a packing list, a certificate of origin and an insurance certificate. The manufacturer ships, presents compliant documents to its bank and is paid under the credit, regardless of any later commercial dispute about the machines.

What types of letters of credit are there?

UCP 600 requires every credit to state whether it is available by sight payment, deferred payment, acceptance or negotiation. Other labels describe additional features.

A standby letter of credit is a different instrument with a different purpose; see our LC vs SBLC vs bank guarantee comparison.

Which documents does a letter of credit usually require?

The credit lists the documents to be presented. The most common are:

• Commercial invoice, made out in the name of the applicant and describing the goods as in the credit.
• Transport document: bill of lading, sea waybill, air waybill, road or rail document, or a multimodal transport document.
• Packing list and weight list.
• Certificate of origin.
• Insurance policy or certificate, when the Incoterms® rule puts insurance on the seller (CIF or CIP).
• Inspection, quality or analysis certificates, when the buyer requires them.

Timing matters. Unless the credit states otherwise, a presentation including original transport documents must be made no later than 21 calendar days after the date of shipment, and in any case before the credit expires. A detailed list of what banks and advisers usually ask for is in our trade finance documents checklist.

What is a discrepancy, and what happens when documents don’t comply?

A discrepancy is any point on which the documents do not comply with the credit, with UCP 600 or with international standard banking practice, as reflected in the ICC’s ISBP 821. Common examples include late shipment, late presentation, an invoice amount above the credit amount, a goods description that conflicts with the credit, missing endorsements, or data in one document that conflicts with another.

The examining bank has a maximum of five banking days following the day of presentation to determine whether the presentation complies. If it refuses, it must send a single notice listing all the discrepancies. The issuing bank may then approach the applicant for a waiver. If the buyer accepts the discrepancies, payment can proceed; if not, the seller has lost the protection of the bank’s undertaking and depends on the buyer.

The most effective protection is upstream: check that every document requested can actually be produced, by the right party, within the deadlines, before the credit is issued or accepted.

How is a letter of credit transmitted between banks?

Banks exchange LCs over SWIFT using Category 7 messages. The main ones are the MT700 (issue of a documentary credit, with MT701 continuations), the MT707 (amendment), the MT710 (advice of a third bank’s credit), the MT720 (transfer) and the MT734 (advice of refusal). Since SWIFT’s 2020 standards release, guarantees and standby letters of credit are issued by MT760, not MT700.

A free-format MT799 is not a letter of credit and creates no payment undertaking. Our guide to SWIFT MT700, MT760, MT799 and MT103 explains what each message proves and what it does not.

How Star Alliance helps with letters of credit

Star Alliance Consulting reviews the underlying transaction, prepares the application file and proposed LC wording, and coordinates with the buyer, the seller and the banks involved. We are not a bank and do not issue credits; the decision to issue or confirm always belongs to the issuing institution. Details are on our letters of credit page, or you can describe your transaction.

Frequently asked questions