When two businesses on opposite sides of the world agree to trade say, an Indian spice exporter and a Gulf-based importer neither party truly knows if the other will hold up their end of the deal. The exporter worries about shipping goods and never getting paid. The importer worries about paying upfront and receiving nothing in return. This is exactly the gap a Letter of Credit (LC) was built to close.
A Letter of Credit is a financial document issued by a bank that guarantees payment to an exporter on behalf of an importer provided the exporter submits all the documents specified in the LC exactly as required. In effect, the bank steps in as a trusted middleman, replacing "trust between two strangers" with "trust in a regulated financial institution." This single shift is what allows global trade to function at scale. An exporter in Cochin doesn't need to personally trust an importer in Jeddah they only need to trust that importer's bank.
A Global Rulebook: The UCP
Trade between two countries means two different legal systems, two sets of banking norms, and two languages of doing business. To prevent this from turning into a mess of disputes, the International Chamber of Commerce (ICC) — founded in 1919 began publishing the Uniform Customs and Practice for Documentary Credits (UCP) in 1933. It has been revised periodically since, and the current version, UCP 600, has governed global LC practice since July 2007. UCP 600 is voluntarily adopted into contracts by banks, exporters, importers, and shipping lines across the vast majority of countries making it one of the most successful private rulebooks in the history of international commerce.
The Four Key Players
Every Letter of Credit transaction involves four parties, each with a distinct role:
1. Applicant: the buyer/importer who requests their bank to open the LC.
2. Beneficiary: the seller/exporter who will ultimately receive payment.
3. Issuing Bank: the applicant's (buyer's) bank, which issues the formal guarantee.
4. Advising Bank: the beneficiary's (seller's) bank, which authenticates and forwards the LC to the exporter. In many transactions, this bank is also separately designated as the Nominated Bank - the bank specifically authorized to pay, accept, or negotiate the documents. These two roles are related but not always identical.
Types of Letters of Credit
Not all LCs are the same - the right type depends on the risk profile, payment timing, and structure of the trade relationship:
• Irrevocable LC: cannot be amended or cancelled without consent from all parties. Under UCP 600, every LC is treated as irrevocable by default, even if not explicitly stated.
• Confirmed LC: a second bank (usually in the exporter's country) adds its own guarantee, doubling the payment assurance.
• Sight LC: payment is made immediately upon presentation of compliant documents.
• Usance/Deferred LC: payment is made at a future date after document acceptance, effectively giving the buyer short-term credit.
• Standby LC: functions like a safety net, only drawn upon if the applicant fails to fulfil their contractual obligation.
• Revolving LC: automatically renews for repeated shipments/transactions without needing a new LC each time.
• Transferable LC: allows the original beneficiary to transfer all or part of the credit to a second beneficiary, common in trading/intermediary arrangements.
Key Takeaways
• A Letter of Credit shifts payment risk from "trust between trading partners" to "trust in regulated banks."
• The ICC's UCP framework (first published 1933, current version UCP 600) provides the global rulebook that makes LCs interpretable and enforceable across borders.
• Four parties are always involved: Applicant, Beneficiary, Issuing Bank, and Advising/Nominated Bank.
• Under UCP 600, LCs are irrevocable by default the "Revocable LC" is largely a legacy concept today.
• Choosing the right LC type (Sight vs. Usance, confirmed vs. unconfirmed, Transferable vs. standard) depends on the risk appetite and cash-flow needs of both trading parties.
Frequently Asked Question
Q1 : Is a Letter of Credit the same as a bank guarantee?
Not quite. An LC is a primary payment mechanism the bank is expected to pay once documents comply. A bank guarantee is typically a secondary obligation, triggered only if the applicant defaults (this is closer to how a Standby LC behaves).
Q2 : What happens if the documents don't match the LC exactly?
This is called a "discrepancy." Banks examine documents strictly under UCP 600, even minor mismatches can allow the issuing bank to refuse payment until they're corrected or the applicant waives the discrepancy.
Q3 : Who pays the bank charges for opening an LC?
This is negotiated between buyer and seller and stated in the sales contract commonly the applicant bears issuing bank charges, while charges of the advising/confirming bank may be split or borne by the beneficiary.
Q4 : Why would an exporter ask for a Confirmed LC instead of a regular one?
If the exporter doesn't fully trust the political or financial stability of the issuing bank's country, a Confirmed LC adds a second guarantee from a bank in their own country reducing country and bank-default risk.
Q5 : Can an LC be cancelled once issued?
Under UCP 600, no LCs are irrevocable by default, meaning they cannot be cancelled or amended without agreement from all parties, including the beneficiary.
Q6: Is UCP 600 legally binding, or just a guideline?
It's not law it's a set of rules that becomes binding only when a Letter of Credit explicitly states it is subject to UCP 600 (which is the near-universal practice in trade finance today).