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A letter of credit (LOC) is a promise from a bank to make a payment after verifying that somebody meets certain conditions.
The easiest way to understand how LOCs work is to see an example, and this tutorial describes the process step-by-step. You can also just read an overview if you prefer a text-only explanation without the visuals.
For this example, we assume that an importer is buying goods from an exporter. However, LOCs are useful in several types of transactions. Standby letters of credit, for example, can work within the U.S. for a variety of services, including building projects, signing up for electrical service, and more. If you want to see how a LOC works for common domestic transactions, replace the terms “importer” and “exporter" with a customer or service provider in your industry. For example:
This tutorial illustrates the basic concepts, but a real transaction is much more complicated than what you see here. For now, the idea is just to get comfortable with the flow of documents and payments with LOCs.
First, a buyer (importer) and seller (exporter) decide to do business together. They agree on a price, quantity, and other terms, and they specify how and when the goods will be shipped to the buyer. As part of the contract, we assume that the seller requires the buyer to use a letter of credit (LOC).
Why does the seller demand a letter of credit? The seller wants more confidence that the buyer will pay. Perhaps this buyer and seller have never worked together, or the order might be large enough to cause severe financial hardship if something goes wrong. For example, if the seller spends money to produce and ship goods, the seller wants to recoup those costs. The buyer might not pay for several reasons (the buyer’s assets could be seized for some reason, the buyer might go bankrupt, and so on).
The sales agreement is not part of a letter of credit. The sales agreement is between the buyer and the seller only, and the LOC relies on information in the agreement, but the LOC is a separate document issued by a bank.
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To obtain the LOC, the buyer contacts her bank. That bank operates in the buyer’s home country, and is most likely a bank that the buyer currently does business with. The buyer provides information required for the bank to issue the LOC, including:
Details matter: It’s essential that the bank gets all of the details correct. The LOC is a legally binding contractual commitment. These documents are interpreted exactly as written. Again, the LOC is separate from the sales agreement, and it’s based on documents—not actions performed—so you can't assume that everything will work out if there’s an error in the LOC. Even a seemingly minor item, like a typographical error, can cause problems. If the document isn’t perfect, it needs to be corrected before anybody moves forward.
Funding: When the bank issues the LOC, the bank makes a promise, and the bank is responsible for sending money. That’s what makes a letter of credit so safe for sellers—the fact that the bank takes responsibility for payment. Because of that, the bank needs to be confident that the buyer can fund the payment. Before the bank issues the LOC, the buyer may have to deposit funds with the bank, or the bank might arrange financing for the buyer as part of the LOC.
Banks and intermediaries: After issuing the LOC, the bank sends it to the seller’s bank. That bank is typically located in the seller’s country and is likely a bank that the seller already has a relationship with. There may be several banks in between acting as intermediaries, but those are left out for simplicity.
Seller review: The seller’s bank reviews the LOC and forwards it to the seller. At that point, the seller must review the LOC to ensure that it matches what she agreed to do and that she is capable of meeting the requirements of the LOC. She should also decide if she is comfortable trusting the issuing bank and any other banks involved.
If everything is acceptable, the seller can move to the next step: produce and ship goods.
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To receive payment with a LOC, the seller must satisfy the requirements specified in the LOC. Among other things, that usually means:
Seller confidence: The seller knows that she will get paid as long as she meets the requirements of the LOC (and assuming the banks involved remain solvent and follow through on their obligations). It doesn’t matter if her customer goes bankrupt or decides not to pay—the bank is on the hook for payment. The end customer’s financial situation is the bank’s problem, not the seller’s problem.
Delivery not required: Depending on the details of the LOC, it doesn’t even matter if the goods ever make it to the customer. A storm may damage or destroy products during shipment, but the seller might not be responsible for that loss if they just had to ship goods.
Documentary requirements: The primary challenge for the seller is meeting the requirements of the LOC. Again, banks only care about the details written into the LOC and the documents you submit to satisfy the LOC. If anything is off, the seller won’t get paid.
For example, if you ship one day late, it’s a major problem. You might throw in some extra product for free (and your customer might even agree that this makes up for the late shipment), but banks won’t pay unless the LOC is amended to account for the later shipping date. It takes extra money and time to revise a LOC.
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Once documents arrive at the seller’s bank, the bank verifies that the documents meet the requirements of the LOC. Again, the bank takes everything literally: If anything doesn't match—even the spelling or abbreviation of a company name—the bank can refuse payment. Banks take several business days to conduct this review.
If the documents are in good order, the seller’s bank forwards the documents to the buyer’s bank. The buyer’s bank performs the same review of documents against the LOC. If everything checks out, the buyer’s bank sends payment to the seller’s bank.
Next, the buyer’s bank forwards the documents to the buyer, who uses those documents to take possession of the goods when they arrive.
When does the seller get paid? The timing of payment depends on the type of LOC used. The seller might get paid within a few days of submitting documents to a local bank. In other cases, the seller waits until certain conditions are met. Sometimes, the seller gets paid an “advance” (before shipping anything) so they can buy materials needed to produce the customer’s goods.
The fee for a letter of credit varies by lender, but it's usually a small percentage of the total funding amount that's being guaranteed.
While a standard letter of credit guarantees payment in the transaction, a standby letter of credit only guarantees payment if something fails to happen. For example, if the buyer faces a cash flow crisis or goes out of business, a standby letter would ensure payment from the issuing bank.
The buyer typically pays the costs of securing a letter of credit. In some cases, though, the cost could be shared between buyer and seller.
