
A documentary credit, also known as a letter of credit, is a widely used financial instrument in international trade.
A documentary credit is essentially a promise from a bank to pay a seller a certain amount of money when the seller presents specific documents, such as a bill of lading and an invoice, as proof of shipment and sale.
The buyer typically opens a documentary credit with their bank, which then issues a credit to the seller's bank. This credit is usually in the form of a letter, hence the name "letter of credit."
The letter of credit serves as a guarantee for the seller, ensuring they receive payment for their goods or services.
What Is a Letter of Credit
A letter of credit is a financial instrument that guarantees payment to a seller upon presentation of specific documents. It's essentially a promise from a bank to pay a certain amount of money to a seller if the buyer fails to pay.
The letter of credit is usually issued by a bank at the request of a buyer and is used to secure payment for goods or services sold. It's a common practice in international trade.
The letter of credit is typically issued in a specific amount, known as the face value, and is valid for a certain period of time. This can range from a few days to several months.
To be eligible for a letter of credit, the buyer must have a good credit history and a solid financial standing. This ensures that the bank can rely on the buyer to fulfill their obligations.
The letter of credit is usually issued in a specific format, including the name of the buyer, the name of the seller, and the amount of the credit. It also includes a description of the goods or services being sold.
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How it Works
A letter of credit is essentially a guarantee that the payment will be made, issued by a bank to the seller.
The bank will pay the seller directly, and it's a negotiable instrument, so the seller can assign the right to draw to another entity if needed.
To get a letter of credit, the buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay.
Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit.
The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.
How it Works
A letter of credit is issued by a bank to guarantee payment to a seller, essentially assuming the responsibility of ensuring the seller is paid.
The bank requires the buyer to prove they have enough assets or a sufficient line of credit to pay before issuing the letter of credit. This typically involves a pledge of securities or cash as collateral.

The issuing bank pays the beneficiary or any bank nominated by the beneficiary, and may charge a fee, usually a percentage of the letter of credit.
International trade often relies on letters of credit to signify that a payment will be made on time and in full, as guaranteed by a bank or financial institution.
The bank will advise the seller of the payment terms, and if the buyer defaults, the issuing bank will be liable to oblige the beneficiary's demand with the help of the advising bank.
Letters of credit come in various types, including revolving, commercial, and confirmed, each with its own specific characteristics and requirements.
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Usance
A Usance Letter of Credit is a type of LC that allows the buyer to pay at a proposed date after the conforming documents are presented by the seller to the advising bank.
This type of LC gives the buyer the privilege to extend the payment schedule to collect the documents from the issuing bank. The payment is payable before the maturity date as agreed by both parties.
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Key Concepts
A letter of credit is a document sent from a bank or financial institution that guarantees a seller will receive a buyer's payment on time and for the full amount. This is a crucial aspect of international trade, where trust and security are essential.
Banks collect a fee for issuing a letter of credit, which is a cost that both parties may need to consider when using this financial tool.
Letters of credit are often used within the international trade industry, providing financial security to both parties involved in a transaction. This is particularly important for sellers who want to mitigate risks associated with international legal systems and lack of trust with buyers.
Here are some key types of letters of credit:
- Revolving letter of credit
- Commercial letters of credit (also known as traditional letters of credit or L/Cs)
- Standby letters of credit
Key Takeaways
A letter of credit is a document sent from a bank or financial institution that guarantees a seller will receive a buyer's payment on time and for the full amount.
Letters of credit are often used in the international trade industry, which can be a complex and high-risk area of commerce.
There are many different types of letters of credit, including revolving letters of credit, which can be useful for frequent buyers and sellers.
Banks collect a fee for issuing a letter of credit, so it's essential to factor this cost into your business planning.
To help you navigate the world of letters of credit, here are some key takeaways:
- A letter of credit guarantees payment for a buyer.
- Letters of credit are often used in international trade.
- There are different types of letters of credit, including revolving letters of credit.
- Banks collect a fee for issuing a letter of credit.
Standby
A standby letter of credit is essentially an insurance contract that protects one party if the other party fails to perform their duty or meet certain service level agreements.
It provides payment if something does not occur, which is the opposite of how other types of letters of credit are structured.
A standby letter of credit is an irrevocable guarantee or a commitment issued by a bank or financial institution, promising to pay on behalf of the applicant.
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It's similar to a documentary letter of credit, but only becomes operative if the applicant defaults.
The beneficiary can then draw on the standby letter of credit and demand payment.
A standby letter of credit is a promise to pay, not a payment itself, making it a crucial risk management tool for businesses.
Commercial Letters of Credit
Commercial letters of credit are a direct payment method where the issuing bank makes payments to the beneficiary. This is in contrast to standby letters of credit, which are a secondary payment method.
Commercial letters of credit are often used in international or domestic trade to facilitate payment under contracts of sale. They are a useful tool for sellers concerned about the creditworthiness of their buyers or the jurisdiction in which they are located.
Commercial letters of credit can be used as a method of payment under contracts of sale because they provide a secure way for sellers to receive payment. The International Chamber of Commerce (ICC) has developed standard rules and guidance to govern letters of credit, known as the Uniform Customs and Practice (UCP) for Documentary Credits.
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Commercial
Commercial letters of credit are a direct payment method where the issuing bank makes payments to the beneficiary. They're often used in international or domestic trade to ensure payment under contracts of sale.
Commercial letters of credit are a useful tool for sellers who have concerns over the creditworthiness of their buyers or the jurisdiction in which their buyers are located. They're also referred to as traditional letters of credit or L/Cs.
A commercial letter of credit is issued by a bank at the buyer's request in favour of the seller, undertaking to pay an agreed sum of money against tender by the seller of the shipping documents. This type of letter of credit is distinct from another form of 'letter of credit' issued by a bank in favour of its own customer.
The Uniform Customs and Practice (UCP) for Documentary Credits is a set of standard terms and conditions that can be incorporated into a letter of credit if the parties concerned wish to use them. The UCP does not have the force of law but is internationally recognised.
Revolving
A revolving letter of credit is a great option for businesses that need to make frequent shipments. It allows a customer to make any number of draws within a certain limit during a specific period.
This can be particularly useful for companies that regularly send out merchandise, as it eliminates the need to constantly redraft or edit letters of credit.
Document Against Acceptance (DA)
Document Against Acceptance (DA) is a type of letter of credit where payment is made upon acceptance of the draft by the beneficiary, meaning the buyer acknowledges their debt. This type of payment is considered high-risk for the seller, as it relies on the buyer's good faith to make payment.
The International Trade Administration notes that DA terms are often not used due to this risk. Instead, Usance LC with acceptance message is used, which allows for payment upon acceptance of the draft. This approach is often preferred by sellers who want to ensure timely payment.
In a DA transaction, the beneficiary and advising bank demand the release of documents solely upon their risk. This means the seller is taking on the risk of non-payment, as they will only receive payment after the buyer has accepted the draft.
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Frequently Asked Questions
What is the difference between LC and documentary collection?
Unlike Letters of Credit, Documentary Collections don't guarantee payment and banks don't verify document accuracy, making them a lower-risk, lower-cost alternative for international trade
What's the difference between LC and DLC?
LCs and DLCs are related but distinct concepts, with DLCs being a subset of LCs that specifically focus on documentary requirements. Understanding the difference between these two financial instruments can help you navigate complex transactions and ensure smooth business operations
Sources
- https://www.investopedia.com/terms/l/letterofcredit.asp
- https://intradefinance.com/letter-of-credit/
- https://www.linkedin.com/pulse/what-documentary-letter-credit-dlc-lakay-business-ltda
- https://www.lexisnexis.co.uk/legal/glossary/documentary-letter-of-credit
- https://docs.oracle.com/cd/E64763_01/html/LC/LC17_Annex_D.htm
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