A letter of credit is a bank's promise to pay the seller once the seller hands over documents that match the credit. The documents are the point. The bank pays because the paperwork conforms, not because the goods turned up in good order, and almost everything else about the instrument follows from that: why the terms are so strict, why most presentations are refused the first time, and why the paperwork is where a first-time importer loses money rather than the shipping.

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What is a letter of credit?

It is a written undertaking from a bank, given on the buyer's behalf, to pay the seller once the seller presents documents that comply with the credit.

The reason they exist is familiar enough. You are shipping to a company you have never met, several thousand miles away, under a contract you would struggle to enforce, and chasing a debtor in another jurisdiction is slow, expensive, and often not worth doing. A credit takes your customer's promise to pay out of the deal and puts a bank's promise in its place - NatWest calls it 'an irrevocable undertaking by a bank on behalf of the buyer… provided the documents presented comply'.

A letter of credit is also a documentary credit, which is the name the international rules use, so if your bank says 'DC' it means the same thing. It is one instrument within trade finance, the wider family that covers importing, exporting, and domestic trade.

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When a letter of credit is worth it, and when it isn't

A credit is the strongest payment protection a seller can get short of being paid in advance, and it is the most work. business.gov.uk, the government's export support service, puts the test simply: use one 'when your exports are high value and you can't get certainty of payment by any other method', and its drawbacks are that a credit 'takes time to prepare and must be drafted with care' and that 'additional fees will apply'.

What you get for that is real. You can trade with a customer you have no history with, in a market where you would otherwise want paying up front, and because the terms are negotiable in advance, the documents, the shipping arrangements, and any inspection you want go in before anyone commits.

Two lighter alternatives are worth knowing first. On open account your customer pays after delivery, typically at 30, 60, or 90 days from the invoice: cheap, quick, and fine for a customer you trust. A documentary collection sits in between, where your bank sends the shipping documents to your customer's bank, which releases them only against payment or against acceptance of a bill of exchange. business.gov.uk notes it 'can be quicker and cheaper to use than Letters of Credit', though no bank is guaranteeing payment. Trade credit insurance covers a different risk again: your customer not paying at all, rather than when.

If what you need is not protection but cash while you wait, that is a different product. Finance against the invoice or funding an export order is where to look.

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How a letter of credit works, stage by stage

The order of events matters more than the vocabulary, because every deadline in the credit hangs off one of these steps.

1. You and your customer agree in the sales contract that payment will be by letter of credit, and agree which documents it will call for.
2. The buyer applies to their own bank. That bank is the issuing bank, and it decides whether to issue, on the buyer's creditworthiness.
3. The issuing bank issues the credit and sends it to a bank in the seller's country, which passes it on. That bank is the advising bank.
4. The seller checks the credit against what was agreed. This is the moment to get changes made, not later.
5. The seller ships, and assembles the documents the credit asks for: the transport document, the commercial invoice, usually a packing list, often a certificate of origin or an inspection certificate.
6. The seller presents them to the nominated bank, whichever bank the credit names, on or before the expiry date. Where that is a bank in your own country, you find out faster whether your paperwork has passed.
7. The bank examines them. If they comply, it pays at sight, or commits to pay at the end of whatever period the credit sets.

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The four banks, and what each one owes you

The issuing bank is the buyer's bank, and the one making the promise. Under the rules it is 'irrevocably bound to honour as of the time it issues the credit', which is why the credit is worth more to you than your customer's signature.

The advising bank only passes the credit on. It signifies that it 'has satisfied itself as to the apparent authenticity of the credit' and that the advice matches what it received, and that is all. Advising is a check, not a promise, and this is the distinction most often misread.

A confirming bank adds its own undertaking on top, and once it has it is 'irrevocably bound to honour or negotiate' – so you are relying on a bank you have chosen rather than one in your customer's country. Confirmation is neither automatic nor free: a bank asked to confirm can decline and simply advise instead, and NatWest's own wording is that when exporting to developing countries it 'may consider' confirming.

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The bank pays against the paperwork, not the goods

This is the sentence to take away, and the rules put it in one line: 'Banks deal with documents and not with goods, services or performance to which the documents may relate' (UCP 600, article 5).

A credit is also 'a separate transaction from the sale or other contract on which it may be based', and banks are 'in no way concerned with or bound by such contract'. So it does not promise you that the goods will arrive, that they will be what you ordered, or that they will be fit to sell. If the documents conform and the container holds the wrong thing, the bank still pays and your argument is with your supplier. If the goods are perfect and the invoice describes them in words that do not match the credit, the bank can refuse.

Which is why buyers who use credits seriously write an independent pre-shipment inspection certificate into the documents the credit requires. The bank will not look at your cargo. It will check that the certificate is there and says what the credit said it should.

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Why payment stalls

Discrepant paperwork, almost always. Nobody publishes a hard figure for how often: the ICC Banking Commission's senior technical advisor puts the share of presentations 'refused on first presentation' at between 60% and 75%, with the caveat that global statistics differ and regional differences are large. Treat it as what it is, an estimate from the people closest to the data, and plan on your first presentation coming back.

The standard the examiner applies is narrower than it sounds. Data in a document 'need not be identical to, but must not conflict with' the credit or the other documents, so a harmless variation is not fatal. But the goods description in the commercial invoice 'must correspond with that appearing in the credit', and that one is strict. Draft the invoice from the credit, not from your own system.

Three deadlines cause more refusals than anything else:

• The latest shipment date in the credit, which is the latest date that can appear on the transport document.
• Twenty-one calendar days. Where original transport documents are involved, you must present no later than 21 calendar days after shipment, and before the credit expires.
• The expiry date itself, the last day a presentation can be made.

A bank that decides a presentation does not comply must tell you in a single notice, listing every discrepancy it is relying on and what it is doing with the documents, by the close of the fifth banking day after presentation. Each examining bank also gets up to five banking days to make the decision, so a refusal can take a working week out of your cash flow before you hear about it.

A refusal is not the end of the road – the issuing bank 'may in its sole judgement approach the applicant for a waiver of the discrepancies', and plenty of credits are paid that way. But look at your position: you shipped against a bank's promise, and you are now asking your customer, the counterparty the credit existed to take out of the equation, whether they would still like to pay. Correct and re-present inside the deadlines if you possibly can.

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Getting one: what your bank will want

If you are the buyer, this is a credit application, not an administrative one. You do not write a letter of credit; your bank issues it, and only if it is willing to lend you the money behind it. NatWest says so directly: an import letter of credit is a commitment given by the bank 'to pay your supplier on your behalf using a credit facility that you have pre-agreed', and its terms add that 'security may be required'. Where there is no facility, banks will usually want cash held against the credit instead.

If you are the seller you need much less. Your customer pays to have it issued, and HSBC notes that receiving one gives 'easier access to financing without the need for a credit facility'. What you may choose to pay for is confirmation, and discounting if the credit is usance.

The clearing banks and the specialist trade banks all do this, and a freight forwarder or your chamber of commerce can prepare the documents for you. Start with your own bank, because the decision is partly about your company rather than the product, and ask four things: what facility or cash cover do you need, what will the issuing commission be, will you confirm credits from this country, and will you check our draft documents before we present them.

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What it costs

Fees arrive in pieces rather than as one headline rate, and the honest answer is that the biggest piece is not published. Here is what one UK bank does publish, from the Bank of Scotland and Lloyds Banking Group international services tariff, correct as at January 2023:

That is one bank's tariff rather than a market rate, and the lines that matter most to a buyer are the two that say 'subject to arrangement'. The issuing commission is priced as credit, on your company, so it is the first thing to ask about and the one thing you cannot look up.

You can still do the sum on the published part. On a £40,000 order the examination charge falls below the minimum, so you pay the £60 floor; add one amendment at £50, because almost every credit gets amended, and one refused presentation at £50, and the published charges alone come to £160 – before the commission, and before whatever your freight forwarder charges to prepare the documents. That is the arithmetic that tells you whether an order is big enough to be worth a credit.

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Types of letter of credit

Most of the terms you will hear describe one feature of a credit rather than a separate product.

Irrevocable. Every credit is. The rules define a credit as an arrangement that 'is irrevocable and thereby constitutes a definite undertaking of the issuing bank', and nothing can be amended or cancelled 'without the agreement of the issuing bank, the confirming bank, if any, and the beneficiary'. So irrevocable is not an upgrade you ask for: it is the normal case, and your customer cannot change the terms behind your back.

Confirmed or unconfirmed. Unconfirmed, only the issuing bank is on the hook. Confirmed, a second bank adds its own undertaking. Ask for confirmation where the country or the bank gives you pause, and expect to pay for it.

Sight, usance, or deferred payment. When you get the money. Under a sight credit the bank pays on presentation of complying documents. Under a usance or deferred payment credit it commits on presentation and pays at the end of an agreed period after shipment, which is your customer's credit period funded by you – HSBC describes it as a credit where 'supplier credit is embedded in the LC'. So price a usance credit into the order.

Transferable. Lets an intermediary pass its rights under the credit to the supplier actually shipping. Useful if you are a trading company.

Back-to-back. Two separate credits instead of one transferred credit, for the same situation when a transfer will not work. HSBC notes it also 'provides trade confidentiality', which is often the real reason.

Revolving. Covers repeated shipments between the same buyer and seller without a new credit each time.

Standby. The odd one out, and worth getting straight because people use it interchangeably with a bank guarantee. A standby behaves like a guarantee: it is drawn only if the other side defaults, whereas a commercial credit is the route by which payment is expected to happen. HSBC puts it well – a letter of credit is a payment and risk-mitigation tool, a guarantee is triggered by a default, and 'payment under a compliant Letter of Credit is expected'. So if someone has asked you for a standby, they want security against your failure to perform, not a way to pay you.

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The rules behind it: UCP 600

Letters of credit are governed by the Uniform Customs and Practice for Documentary Credits, published by the International Chamber of Commerce. The current version is the 2007 revision, ICC Publication no. 600, known as UCP 600. The ICC's banking commission approved it on 25 October 2006 and the implementation date was 1 July 2007. It cut the rules from 49 articles to 39 and replaced the old 'reasonable time' for accepting or refusing documents with a maximum of five banking days.

Two things are worth knowing even if you never read them. They apply to a credit only when the credit says they do, and then they bind every party unless the credit expressly changes or excludes something – which is the reason to read the credit you are sent rather than assume it is standard, because the parts most often excluded are the ones that protect you. And they cover a standby letter of credit only 'to the extent to which they may be applicable'.

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What a letter of credit doesn't protect you from

The terms are strict, which means delay and paperwork. Credits are expensive to issue and not worth it for every order. Not every market expects one, and in some trades they are not standard practice. If either side arrives with a list of non-negotiable stipulations, drafting the thing will cost you both time and money. And a credit will not help you with a dispute about the quality of what turned up, because by then the bank has done its job and gone.

Two more, from the rules. A document you present that the credit did not ask for 'will be disregarded and may be returned'. And a condition with no document specified to show you have met it is 'deemed as not stated' and ignored, so a reassuring clause with no document behind it is not protection.

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What a letter of credit ties up

For the buyer, quite a lot. An import credit runs on a facility your bank has pre-agreed with your company, or on cash it holds against the credit, and it stays tied up for the life of the credit – which runs to expiry, not to shipment. The money is committed through the drafting, the shipping, the presentation, and any round of corrections. If that facility is also what you were going to use for stock or a tax bill, the credit has quietly taken it. For the seller it is the other way round: receiving a credit costs you fees, not capacity.

We do not issue letters of credit, and we are not going to pretend the gap above is one we fill. What we do lend is working capital through our Flexi-Loan.

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