Key Takeaways
A Letter of Credit (LC) is one of the most important financial tools in international trade. It is a bank’s written commitment to pay the exporter, provided the exporter ships the goods and presents the correct documents within the agreed deadline. The LC protects both sides: the buyer does not release payment until shipment is confirmed, and the seller has a bank guarantee — not just a buyer’s promise — backing the deal. Understanding how a Letter of Credit works is essential knowledge for any exporter handling orders above a few thousand dollars.
Table of Contents
Understanding the Letter of Credit
Think of a Letter of Credit as a neutral third-party guarantee inserted between the buyer and the seller. Instead of trusting each other — two businesses that may have never met, operating across different legal systems and currencies — both sides trust the banks involved. That is the elegance of the LC structure, and it is why it has been the backbone of international trade finance for over a century.
The International Chamber of Commerce (ICC) sets the global rules governing LCs through the Uniform Customs and Practice for Documentary Credits (UCP 600) — the most widely used commercial rulebook in the world. When an LC states “subject to UCP 600,” both the exporter’s bank and the buyer’s bank operate under the same standardized framework, regardless of which countries they are in.
In our experience, exporters who understand the LC mechanism from the inside out are far better positioned to negotiate favorable terms, avoid discrepancies, and get paid on time. Those who treat it as a paperwork formality are the ones who most often run into problems. If you are still building the foundations of your export operation, our guide on how to run an export business for beginners is a useful primer before diving into LC mechanics.
How a Letter of Credit Works: Step-by-Step
Step 1 — Sales Contract Agreement
The process starts with a sales contract between the exporter and the importer. Both parties agree that payment will be made via Letter of Credit and specify the key LC terms: currency, amount, shipment deadline, destination port, and required documents.
Step 2 — Buyer Applies for the LC at Their Bank
The buyer (importer) goes to their bank — called the issuing bank — and applies for an LC. The bank reviews the buyer’s creditworthiness and, if approved, issues the LC: a formal document outlining the exact terms under which payment will be released to the exporter.
Step 3 — LC Transmitted to the Exporter’s Bank
The issuing bank transmits the LC to the exporter’s bank — called the advising bank (or confirming bank if it adds its own guarantee). The advising bank authenticates the LC and forwards it to the exporter. This is your signal that a real bank has committed to your payment.
Step 4 — Exporter Reviews the LC Carefully
This is arguably the most critical step — and the one most commonly skipped. Before you produce or ship a single item, read every single LC condition against your actual capabilities. Can you ship by the stated deadline? Can you provide every required document? Is the port of loading correct? Is the product description exactly right?
Field note: We have seen deals collapse because the LC specified a certificate of origin from a chamber of commerce that does not offer that specific format. If any condition is impossible or unclear, request an amendment from the buyer immediately — before you begin production.
Step 5 — Exporter Ships the Goods
Once you have confirmed you can comply with all LC terms, you produce and ship the goods. Your freight forwarder is essential at this stage — they will help ensure your Bill of Lading, packing list, and other shipping documents are issued exactly as the LC specifies.
Step 6 — Present Documents to Your Bank
After shipment, you gather all the required documents — typically the commercial invoice, Bill of Lading, packing list, certificate of origin, and any additional certificates stated in the LC — and present them to your advising bank before the LC’s document presentation deadline.
Step 7 — Banks Verify Documents and Release Payment
Your bank reviews the documents for compliance, then forwards them to the issuing bank. The issuing bank has a maximum of five banking days to check and either accept or reject. If documents are compliant, payment is released to you — regardless of whether the buyer accepts or disputes the goods. The bank pays against documents, not against the physical shipment.
Types of Letters of Credit You Should Know
Irrevocable LC: Cannot be cancelled or changed without the agreement of all parties. This is the standard in modern trade — always insist on an irrevocable LC.
Confirmed LC: Your own bank (advising bank) adds its own payment guarantee on top of the issuing bank’s commitment. This is the strongest form of LC protection — particularly important for buyers in countries with political or financial instability.
Sight LC vs. Usance (Deferred) LC: A sight LC pays immediately upon presentation of compliant documents. A usance LC specifies a payment delay (e.g., 60 or 90 days after presentation) — effectively extending credit to the buyer. As an exporter, always prefer sight payment unless you are intentionally financing the buyer.
Transferable LC: Allows you to transfer part or all of the LC to a secondary supplier. Useful for trading companies who are acting as intermediaries.
Common Pitfalls & Expert Tips
Pitfall 1: Document Discrepancies
Studies by the ICC consistently show that over 50% of first-presentation LC document sets contain at least one discrepancy. Even a minor inconsistency — a typographical error in a product description, a date mismatch between documents, or a missing endorsement — can give the issuing bank grounds to reject payment. In our experience, most discrepancies are preventable with a single pre-shipment document review session with your freight forwarder.
Pitfall 2: Missing the Presentation Deadline
An LC expires. If you present your documents one day late — even if the goods shipped on time — your LC is invalid and you lose your bank payment guarantee. The presentation deadline is non-negotiable. Build buffer time between your shipment date and your document submission to your bank.
Pitfall 3: Accepting an LC Without Confirming It
A common trap we see with new exporters is accepting an LC from a buyer’s bank in a high-risk country without adding confirmation from their own bank. If the buyer’s country goes into financial crisis, the issuing bank may default on its obligation. A confirmed LC eliminates this risk — ask your bank to add confirmation, especially for buyers in emerging markets.
Expert Tip: Create a simple LC review checklist before you accept any LC. It should cover: correct company names, correct port of loading and destination, achievable shipment date, realistic document list, correct currency and amount, and sufficient time between shipment deadline and presentation deadline. Use this checklist on every LC you receive, without exception. For a full picture of how payment terms fit into your export strategy, see our guide on export payment terms for international trade.
If you are sourcing export-ready products to fulfill international orders, TheExporter.co provides high-quality handmade and authentic Indonesian furniture — products that come with established documentation support to help you meet the shipping and certification requirements that LC transactions demand.
Frequently Asked Questions
1. Who pays for the Letter of Credit — buyer or seller?
The buyer typically pays the issuing bank’s fees for opening the LC. The exporter pays their advising or confirming bank’s fees. Bank charges vary by country and institution, but typically range from 0.1–0.5% of the LC value per quarter. These costs should be factored into your pricing when negotiating deals where the buyer requests LC terms.
2. What happens if the buyer refuses to pay despite a compliant LC?
Under an irrevocable LC with compliant documents, the issuing bank is legally obligated to pay regardless of any dispute between the buyer and seller. The buyer’s refusal to authorize payment is irrelevant — the bank’s commitment is independent of the underlying commercial dispute. This is the most powerful feature of an LC from an exporter’s perspective.
3. How long does it take to receive payment under an LC?
Under a sight LC with compliant documents, you typically receive payment within 5–10 banking days after presenting documents to your advising bank. The issuing bank has a maximum of five banking days to review. Usance (deferred) LCs extend this timeline by the agreed credit period — 30, 60, or 90 days beyond the presentation date.
4. Can a small exporter use a Letter of Credit?
Yes. LCs are available for any shipment value, though the fixed bank fees make them more practical for orders above $5,000–$10,000. For very small orders, the bank charges can represent a disproportionate cost relative to the shipment value — in those cases, T/T advance payment is often more efficient.
5. What is a “soft clause” in an LC and why is it dangerous?
A soft clause is a condition in an LC that allows the buyer — or the buyer’s bank — to prevent payment even when documents are compliant, by requiring an additional document or approval that only the buyer can provide. This effectively turns an LC into an open account arrangement. Always have your bank review the LC for soft clauses before accepting. If any clause gives the buyer unilateral control over payment release, reject it and request amendment.