Letter of Credit: Definition, Types, and Process Explained

Introduction

A Letter of Credit (LC) is a financial instrument issued by a bank that guarantees payment from the buyer to the seller. It ensures that the seller receives timely and complete payment for goods or services, even if the buyer fails to fulfill their payment obligation. In such cases, the bank steps in to pay the full or remaining amount on behalf of the buyer.

A letter of credit is usually issued against collateral such as cash or pledged securities. Banks charge a fee for this service, which is generally calculated as a percentage of the total value of the letter of credit.

Why Letters of Credit Are Important for Businesses

Due to the complexities of international trade—such as geographical distance, varying legal systems, and limited direct interaction between buyers and sellers—Letters of Credit (LCs) serve as a secure and dependable payment method. They help minimize risk and build trust between parties involved in cross-border transactions.

Letters of credit used in global trade are governed by the Uniform Customs and Practice for Documentary Credits (UCP), established by the International Chamber of Commerce (ICC), which provides standardized rules and guidelines to ensure smooth and consistent international trade practices.

Parties Involved in a Letter of Credit Explained

A Letter of Credit (LC) involves several key parties, each with a specific role in ensuring a secure transaction:

Applicant (Importer): The buyer who requests their bank to issue the Letter of Credit in favor of the seller.
Issuing Bank: The importer’s bank that issues the LC and guarantees payment to the seller (also known as the opening bank).
Beneficiary (Exporter): The seller who receives payment under the terms and conditions specified in the Letter of Credit.

Types of Letters of Credit Explained in Detail

Sight Letter of Credit
Under a sight LC, payment is made immediately upon presentation of valid and compliant documents. Once the seller submits the required documents to the bank, funds are released without delay, making it one of the fastest payment options in trade finance.

Acceptance Credit / Usance (Time) Letter of Credit
This type of LC allows payment after a specified period. The bill of exchange (known as a usance bill) is accepted by the bank upon presentation and is paid on its maturity date.
Example: A buyer receives goods along with the bill and is given a credit period—such as 30 days—to make the payment, which defines the usance period.

Revocable and Irrevocable Letter of Credit
A revocable LC can be modified or cancelled by the issuing bank at any time without prior notice to the beneficiary, offering less security to the seller.
In contrast, an irrevocable LC cannot be changed or cancelled without the consent of all parties involved, making it a more secure and commonly used option in international trade.

Confirmed Letter of Credit Explained

A confirmed Letter of Credit is always based on an irrevocable LC. In this type, a bank other than the issuing bank—usually the beneficiary’s bank—adds its own confirmation to the credit, thereby guaranteeing payment. In such cases, the beneficiary submits the required documents to the confirming bank to receive payment, ensuring an additional layer of security.

Back-to-Back Credit

A back-to-back credit is a type of LC where the exporter (beneficiary) uses the export LC received from the buyer as security to request their bank to issue another LC in favour of their supplier. This helps the exporter procure raw materials or goods needed to fulfill the export order.

Example: An Indian exporter receives an export LC from a buyer in the Netherlands. The exporter then approaches their bank to issue an LC in favour of a local supplier for raw materials. The bank issues this new LC backed by the original export LC.

Transferable Credit

A transferable Letter of Credit allows the beneficiary to transfer part or all of their payment rights to a third party. Although an LC itself is not a negotiable instrument, the rights under a transferable LC can be passed on to another party, such as a supplier.

For this to be valid, the LC must clearly state that it is “transferable,” allowing the beneficiary to assign rights to one or more secondary beneficiaries.

Is There a Fee for a Letter of Credit (LC)?

Banks charge a fee for issuing a Letter of Credit (LC). The cost of an LC varies depending on several factors, including the total transaction amount, the level of risk involved, and the type of letter of credit issued.

In general, higher-value and higher-risk transactions may attract higher charges. The fee structure may also differ based on whether the LC is sight, usance, confirmed, or irrevocable.

How Does a Letter of Credit Benefit Buyers (Purchasers)?

A Letter of Credit (LC) primarily protects the seller by ensuring that payment is received either from the buyer or the issuing bank once the agreed conditions are met. However, it also offers important benefits to the purchaser in certain situations.

For example, if a buyer makes an advance payment but the seller fails to deliver the goods or does not meet the agreed terms, the LC can help protect the buyer’s financial interest. In such cases, the purchaser may be able to recover the amount paid, depending on the terms of the credit. This makes the Letter of Credit a secure payment mechanism that safeguards both buyers and sellers in international trade transactions.

About the Author

Dakesh

Dakesh breaks down complex legal regulations into clear, practical guidance, helping entrepreneurs remain compliant while building sustainable and scalable businesses.

May 4, 2026