Understanding Letter of Credit (LC) in Exports

A Letter of Credit (LC) is a highly secure international payment method where the buyer's bank legally guarantees payment to the exporter, provided the exporter submits flawless shipping documents. While it eliminates credit risk, it introduces severe documentation risk, as any typo can result in delayed or denied payment.

What is a Letter of Credit (LC)?

In international trade, trust is a rare commodity. The buyer doesn't want to pay before receiving the goods, and the seller doesn't want to ship without getting paid. A Letter of Credit (LC) solves this standoff. It is a legally binding economic guarantee issued by a creditworthy bank (the buyer's bank) promising to pay the exporter a specific amount, in a specific currency, provided the exporter submits a highly specific set of shipping documents within a strict timeframe.

How the LC Process Works (Step-by-Step)

1. The Contract: The buyer and seller agree on a sales contract specifying payment via LC.
2. Issuance: The buyer applies to their bank (Issuing Bank) to open an LC in favor of the seller.
3. Advising: The Issuing Bank transmits the LC to the seller's bank (Advising Bank) in India.
4. Review: The seller meticulously reviews the LC to ensure they can meet all the conditions (shipping dates, required documents).
5. Shipment: The seller ships the goods and collects the transport documents (like the Bill of Lading).
6. Presentation: The seller submits all required documents to their bank.
7. Payment: The documents are forwarded to the Issuing Bank. If the documents perfectly match the LC terms, the Issuing Bank releases payment to the seller, regardless of whether the buyer has the funds or even if the buyer goes bankrupt.

Key Types of Letters of Credit

• Irrevocable LC: The standard in modern trade. It cannot be modified, canceled, or changed in any way without the explicit consent of all parties involved (Buyer, Seller, and Banks).
• Confirmed LC: Used when exporting to high-risk countries. A second bank (usually a major international bank or the seller's bank) adds its own guarantee to the LC. If the buyer's bank defaults or the buyer's country suffers an economic collapse, the confirming bank will still pay you.
• At Sight LC: Payment is made immediately (usually within 5-7 banking days) after the compliant documents are presented.
• Usance (Deferred) LC: Payment is made at a later, specified date (e.g., 60 days after the Bill of Lading date), giving the buyer credit.

The Danger of Discrepancies

While an LC eliminates buyer credit risk, it introduces massive documentation risk. Banks deal strictly in documents, not goods. If the LC demands a "Commercial Invoice in 3 copies showing goods as 'Premium Basmati Rice'" and your invoice says "Basmati Rice - Premium", the bank will declare a discrepancy.

A discrepancy means the bank's guarantee to pay is voided. You are suddenly at the mercy of the buyer, who must accept the discrepancy before the bank will pay. Buyers often use discrepancies to force price discounts while the cargo sits incurring demurrage charges at the port.

Conclusion

An LC is incredibly powerful, but you must read it like a hawk before shipping. If you find a condition you cannot meet, ask the buyer to amend the LC immediately. For hands-on help reviewing LC drafts before you accept them, our Consulting Services team offers document vetting for complete peace of mind.

Frequently Asked Questions (FAQ)

Who pays the bank charges for an LC?

This is negotiable. Usually, the buyer pays the issuance fees in their country, and the seller pays the advising and negotiation fees in India. Ensure this is clearly stated in your Proforma Invoice.

Is 100% Advance Payment better than an LC?

For the seller, 100% Advance Payment is always the best and safest method, as there is zero risk and zero bank fees. However, foreign buyers rarely agree to 100% advance with a new supplier, making the LC the best compromise.

What is UCP 600?

UCP 600 (Uniform Customs and Practice for Documentary Credits) is the internationally recognized set of rules established by the International Chamber of Commerce that governs how Letters of Credit operate globally.