Letters of credit: Meaning, Criticisms & Real-World Uses

What Are Letters of Credit?

Letters of credit (LCs) are financial instruments that act as a payment guarantee from a bank to a seller (beneficiary) on behalf of a buyer (applicant). This commitment ensures that the seller will receive payment, provided they present specified documents that prove the goods or services have been shipped or rendered as per the agreement. LCs are a critical component of trade finance, a broader financial category that facilitates domestic and international commerce by mitigating risks and optimizing cash flow for businesses.

A letter of credit essentially shifts the payment risk from the buyer to a bank, offering a secure payment mechanism, particularly in international transactions where buyers and sellers may have limited trust or familiarity. The issuing bank pledges to honor the payment obligation upon presentation of compliant documents, which typically include bills of lading, commercial invoices, and inspection certificates. Letters of credit are particularly valuable for managing counterparty risk and ensuring smooth cross-border trade.

History and Origin

The concept of a letter of credit has ancient roots, evolving from early forms of credit and guarantees used to facilitate trade across vast distances. As international trade expanded, particularly in the early 20th century, the need for standardized practices became evident due to varying national laws and customs.

To address this, the International Chamber of Commerce (ICC) introduced the first version of the Uniform Customs and Practice for Documentary Credits (UCP) in 1933.⁴¹, ⁴² This framework aimed to unify rules governing letters of credit, providing much-needed clarity and reducing commercial risks.⁴⁰ The UCP has undergone several revisions since its inception, adapting to changes in trade finance practices and technological advancements.³⁹ The current iteration, UCP 600, was approved by the Banking Commission of the ICC on October 25, 2006, and formally commenced on July 1, 2007. The UCP 600's 39 articles apply to 175 countries, governing trillions of dollars in trade annually, making them the most successful private rules for trade ever developed.³⁸

Key Takeaways

Letters of credit are bank guarantees for payment in trade transactions, benefiting both buyers and sellers.
They are commonly used in international trade to mitigate the risk of non-payment or non-delivery.
The International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits (UCP) provides a global framework for LCs.
LCs facilitate smoother transactions by shifting payment risk from the trading parties to a bank.
While providing security, letters of credit can involve fees and require meticulous document preparation.

Formula and Calculation

Letters of credit do not involve a specific financial formula or calculation in the way that, for example, an interest rate or return on investment might. Their value is the stated amount of the transaction they guarantee. However, fees associated with LCs are calculated by the issuing and advising banks. These fees typically depend on several factors:

Transaction Amount: The total value of the goods or services being traded.
Risk Assessment: The creditworthiness of the applicant and the country risk of both parties.
Complexity: The intricacy of the transaction and the number of documents involved.
Type of LC: Different types of LCs (e.g., confirmed, unconfirmed) may have varying fee structures.

Banks charge a percentage of the transaction value, along with other administrative fees. For example, if a bank charges a 0.5% commission on a \$100,000 letter of credit, the fee would be \$500. Additional charges might include swift charges, amendment fees, and discrepancy fees if documents are not presented correctly. These fees are part of the overall cost of goods sold or the operational expenses for the involved parties.

Interpreting the Letters of Credit

Interpreting a letter of credit involves understanding its terms, conditions, and the roles of the parties involved. The LC itself is a separate contract from the underlying sale agreement, and banks deal only in documents, not in goods or services. This is known as the "principle of independence."

When evaluating a letter of credit, key elements to interpret include:

Parties: Identifying the applicant (buyer), beneficiary (seller), issuing bank, and any advising or confirming banks.
Amount and Currency: The maximum amount the bank is obligated to pay and the currency of payment.
Expiration Date: The date by which documents must be presented to the bank.
Documents Required: A precise list of documents (e.g., bill of lading, commercial invoice, packing list, certificate of origin, inspection certificate) that the beneficiary must present for payment.
Terms of Shipment: Details such as the latest shipment date, port of loading, and port of discharge.
Specific Conditions: Any other conditions that must be met, such as pre-shipment inspection requirements or specific wording on documents.

Adherence to these details is paramount. Banks will meticulously check for compliance, and even minor discrepancies can lead to delayed payments or rejection. For a successful transaction, both the buyer and seller must understand the specifics of the letter of credit and ensure all stipulated documents are prepared accurately and presented within the given timeframe.³⁷ The International Standard Banking Practice (ISBP) for the Examination of Documents under Documentary Credits (ICC Publication 745) aids in this understanding.³⁶

Hypothetical Example

Consider an electronics manufacturer, "TechGlobal," in South Korea (exporter/beneficiary) selling a large shipment of microchips worth \$500,000 to "AutoParts Inc." a car manufacturer in Germany (importer/applicant). AutoParts Inc. wants to ensure they receive the microchips, and TechGlobal wants to guarantee payment.

Sales Contract: AutoParts Inc. and TechGlobal agree on the terms of the sale, including the price, quantity, quality, and shipment details. They decide to use a letter of credit for security.
LC Application: AutoParts Inc. applies to its bank in Germany, "Deutsche Bank" (issuing bank), to issue a letter of credit in favor of TechGlobal.
LC Issuance: Deutsche Bank issues the LC, detailing all conditions, required documents (e.g., commercial invoice, packing list, bill of lading, certificate of quality), and the payment amount. Deutsche Bank sends the LC to TechGlobal's bank in South Korea, "Seoul Bank" (advising bank).
LC Advising: Seoul Bank verifies the authenticity of the LC and advises TechGlobal that it has been issued.
Shipment and Document Preparation: TechGlobal ships the microchips according to the LC terms. After shipment, TechGlobal gathers all required documents, including the bill of lading from the shipping company, the commercial invoice, and the certificate of quality.
Document Presentation: TechGlobal presents these documents to Seoul Bank.
Document Examination: Seoul Bank examines the documents to ensure they strictly comply with the terms and conditions of the letter of credit. Assuming the documents are compliant, Seoul Bank forwards them to Deutsche Bank.
Payment: Deutsche Bank also examines the documents for compliance. If compliant, Deutsche Bank pays Seoul Bank, which then pays TechGlobal. Deutsche Bank then debits AutoParts Inc.'s account and releases the documents, allowing AutoParts Inc. to take possession of the microchips.

This process ensures that TechGlobal gets paid for its goods once they are shipped and the documents are verified, while AutoParts Inc. is assured that payment is only made after the shipping conditions are met, mitigating payment risk for both parties.

Practical Applications

Letters of credit are widely used in international trade to mitigate risks for both exporters and importers, making cross-border transactions more secure and efficient.³⁴, ³⁵ Their practical applications extend across various industries and scenarios:

International Trade: The most common use is in international sales where the buyer and seller are in different countries and may not have established trust. LCs provide a secure payment mechanism, especially when dealing with new trading partners or in regions with higher country risk.³³
Mitigating Payment and Performance Risk: For exporters, LCs guarantee payment, provided they fulfill their shipping obligations and present correct documentation. For importers, LCs ensure that payment is only made after the goods have been shipped as agreed. This minimizes the risk of non-payment for the seller and non-delivery or non-conforming goods for the buyer.³²
Facilitating Trade Finance: LCs are a cornerstone of the broader trade finance ecosystem, enabling financial institutions to support international commerce by providing various products that help traders manage payments and associated risks.³⁰, ³¹ The World Trade Organization (WTO) estimates that a significant portion of global trade, up to 80-90%, relies on trade finance in some capacity.²⁸, ²⁹
Project Financing: In large-scale projects involving international contractors and suppliers, LCs can secure payments for stages of completion or delivery of critical components.
Commodity Trading: For bulk commodity transactions, where large sums of money are involved and goods often change hands multiple times before reaching the final buyer, LCs provide a layer of security.

Limitations and Criticisms

While letters of credit offer significant benefits in facilitating secure trade, they also come with certain limitations and criticisms:

Cost and Complexity: LCs can be more expensive than other payment methods due to bank fees, which cover the banks' risk and administrative effort.²⁷ The process is also complex, requiring meticulous adherence to documentation requirements.²⁶ Any discrepancy, even a minor one, can lead to delays or rejection of payment, incurring additional fees and potentially disrupting the transaction.
Reliance on Documents, Not Goods: A fundamental principle of LCs is that banks deal solely with documents and not with the actual goods or services. This means that even if the documents are compliant, there could still be issues with the quality or quantity of the goods themselves, which the LC does not cover. The buyer would need to pursue recourse through the underlying sales contract.
Rigidity: The strict adherence to terms and conditions can make LCs inflexible. Any changes to the underlying trade agreement often require amendments to the letter of credit, which can be time-consuming and costly.
Bank Risk Exposure: While LCs mitigate risk for the trading parties, they introduce credit risk for the issuing bank.²⁵ The bank is obligated to pay the beneficiary upon compliant presentation of documents, regardless of whether the applicant ultimately reimburses the bank. The Federal Reserve highlights that letters of credit are among the off-balance sheet items that expose banks to credit risk.²³, ²⁴
Fraud Risk: Despite their security features, LCs are not entirely immune to fraud. Fraudulent documents, although meticulously checked, can sometimes pass undetected, leading to financial losses.
Alternatives Available: For trusted trading partners or smaller transactions, simpler and less expensive methods like open account terms or documentary collections might be preferred.²²

Despite these criticisms, the security and reliability offered by letters of credit often outweigh the drawbacks, particularly for high-value international transactions or when dealing with new or less-established trading relationships.

Letters of Credit vs. Documentary Collections

While both letters of credit and documentary collections are instruments used in international trade to facilitate payments, they differ significantly in the level of security and the roles of the banks involved.

Feature	Letters of Credit (LC)	Documentary Collections (DC)
Bank's Role	Bank issues a binding payment undertaking.	Banks act as facilitators, handling documents and payments.
Payment Guarantee	Yes, conditional upon compliant documents.	No, banks do not guarantee payment.
Risk to Exporter	Low (bank guarantees payment).	Higher (relies on importer's willingness to pay).
Risk to Importer	Low (payment only after documents are presented).	Higher (goods may be shipped before payment is assured).
Governing Rules	Uniform Customs and Practice for Documentary Credits (UCP).	Uniform Rules for Collections (URC).
Cost	Higher (due to bank's commitment and risk).	Lower (fewer bank services and less risk for banks).
Complexity	More complex, requiring strict document compliance.	Simpler, fewer stringent documentation requirements.

In a letter of credit, the issuing bank provides a direct payment commitment, offering a high degree of security to the exporter. This makes LCs suitable for transactions with new trading partners or in high-risk environments. In contrast, a documentary collection involves banks acting as intermediaries to facilitate the exchange of documents against payment or acceptance of a draft. Banks in a documentary collection do not undertake any payment obligation; they simply follow the instructions of the remitting bank. Therefore, the risk of non-payment remains with the exporter.

FAQs

What is the primary purpose of a letter of credit?

The primary purpose of a letter of credit is to provide payment assurance from a bank to a seller (exporter) on behalf of a buyer (importer). It mitigates the risk of non-payment for the seller and non-delivery for the buyer, especially in international trade where trust and familiarity between parties may be limited.

Who are the key parties involved in a letter of credit?

The key parties involved in a letter of credit are the applicant (buyer/importer), the beneficiary (seller/exporter), the issuing bank (the buyer's bank that issues the LC), and the advising bank (the seller's bank that authenticates and forwards the LC to the beneficiary). Sometimes, a confirming bank may also be involved, adding its own guarantee to the LC.

How does a letter of credit protect the buyer?

A letter of credit protects the buyer by ensuring that the bank will only release payment to the seller upon the presentation of specific, compliant documents. These documents typically prove that the goods have been shipped or services rendered according to the agreed-upon terms, safeguarding the buyer against non-delivery or non-conforming shipments. This mechanism helps manage supply chain risk in international transactions.

How does a letter of credit protect the seller?

A letter of credit protects the seller by providing a bank's unconditional undertaking to pay for the goods or services, provided the seller presents all required documents that strictly comply with the terms of the LC. This eliminates the risk of the buyer defaulting on payment or refusing to pay, making it a very secure payment method for exporters. It significantly reduces commercial risk.

What happens if there are discrepancies in the documents presented under a letter of credit?

If discrepancies are found in the documents presented under a letter of credit, the issuing bank (and confirming bank, if any) can refuse to make payment. The beneficiary will then be notified of the discrepancies and usually given an opportunity to correct them or obtain a waiver from the applicant. Unresolved discrepancies can lead to significant delays and additional costs, underscoring the importance of meticulous document preparation. This highlights the concept of operational risk in trade finance.¹ ², ³ ⁴ ⁵ ⁶ ⁷, ⁸ ⁹, ¹⁰ ¹¹ ¹² ¹³, ¹⁴ ¹⁵ ¹⁶ ¹⁷ ¹⁸ ¹⁹ ²⁰, ²¹