Understanding a letter of credit: how it works, costs, and alternatives

A letter of credit is a financial instrument issued by a bank on behalf of a buyer, committing the bank to make payment to the seller once the agreed conditions and documentary requirements have been fulfilled. The buyer then pays back the bank. If the buyer fails to reimburse the bank, the issuing bank remains obligated to honour the letter of credit, provided the conditions set out in the credit have been met.

Letters of credit are often used in international trade, where buyers and sellers may be operating in different countries, legal systems, and regulatory environments. They help reduce uncertainty by providing both parties with greater confidence that payment will be made once the required documentation has been submitted and the agreed terms have been fulfilled.

For sellers, a letter of credit can help reduce payment risk and support cash flow by providing an additional layer of financial security for individual transactions. For buyers, it demonstrates financial credibility and can help build trust with suppliers, especially when they go into new markets or start trading relationships. As a result, letters of credit can form an important part of a credit management policy and can be an effective way of protecting a seller's cash flow.

The letter of credit process involves several key parties, including the buyer (applicant), the seller (beneficiary), and the issuing bank. There may also be others involved, such as an advising bank or confirming bank, depending on the arrangement.

1. The process normally begins when the buyer applies for a letter of credit through their bank. The issuing bank reviews the buyer’s application and financial position before agreeing to provide the guarantee. Once it is approved, the bank issues the letter of credit, and this confirms that payment will be made to the seller if the agreed terms and conditions are met.
2. The seller can proceed with the transaction knowing that payment is supported by the bank’s commitment, provided the terms of the letter of credit are fulfilled. However, payment is usually dependent on the seller providing the necessary documentation, such as proof that goods have been shipped or services have been delivered, in line with the terms outlined in the letter of credit.
3. If the buyer fails to make payment, the seller can submit the required documents to the issuing bank. If the conditions of the letter of credit have been fulfilled, the bank will then make the payment on the buyer’s behalf.

For example, a UK food and beverage exporter agrees to supply a large shipment of packaged goods to a new distributor in the UAE. As the two companies haven't traded together before, the exporter requests a letter of credit to reduce the risk of non-payment.

The UAE distributor applies to their bank for a letter of credit in favour of the UK exporter, confirming payment will be released once conditions are met, such as presenting a bill of lading, packing list, and health and safety certification for the goods. With this assurance, the exporter proceeds with production and shipping.

Once the goods are shipped, the exporter submits the necessary documents to their bank, which passes them to the issuing bank in the UAE to be checked. As the documents meet the agreed terms, the issuing bank releases payment, and the exporter is paid without having to wait for the distributor to receive and inspect the goods. This protects the exporter from the risk of a delayed or refused payment and also gives the distributor confidence that funds are only released once shipment is confirmed. The distributor then pays the bank back.

A letter of credit involves several parties, each with a specific role in making sure the transaction is completed securely.

Buyer (applicant)

The buyer, also known as the applicant, is the party that requests the letter of credit from their bank. They provide the necessary information about the transaction and agree to meet the bank’s requirements before the letter of credit is issued.

For international trade transactions, a buyer may use a letter of credit to give reassurance to a supplier that payment will be made once the agreed conditions are met.

Seller (beneficiary)

The seller, or the beneficiary, is the party receiving payment under the letter of credit. They must meet the terms outlined in the agreement, which usually involves providing specific documents confirming that goods have been shipped or services have been delivered.

A letter of credit can help sellers reduce payment risk, especially when trading with new customers or operating across different countries.

Issuing bank

The issuing bank provides the letter of credit on behalf of the buyer, reviewing the buyer’s application, assessing the arrangement, and committing to making payment to the seller if the required conditions are fulfilled.

The issuing bank’s role is central because it provides the financial assurance behind the letter of credit.

Advising bank

An advising bank is normally the seller’s bank and acts as an intermediary between the issuing bank and the beneficiary, verifying the authenticity of the letter of credit and communicating its terms to the seller.

The advising bank does not usually take responsibility for payment unless it has additional obligations under the arrangement.

Confirming bank

Sometimes, a seller may request additional security by asking another bank to confirm the letter of credit. A confirming bank adds its own commitment to pay, provided the terms of the letter of credit are met.

This can give extra certainty when there are concerns about the issuing bank, political risk, or trading in unfamiliar markets.

Your business can use different types of letters of credit depending on the nature of the transaction, the level of security needed, and the relationship between the buyer and seller. While all letters of credit provide payment assurance when their conditions are met, the structure and purpose can vary.

Commercial letter of credit

A commercial letter of credit is one of the most common types used in international trade. It provides a payment guarantee from the buyer’s bank to the seller, as long as the seller meets the agreed terms and submits the required documentation.

Commercial letters of credit are often used when buyers and sellers don’t have an established trading relationship or when there is increased uncertainty around cross-border transactions.

Standby letter of credit

A standby letter of credit (SBLC) works as a secondary financial guarantee that can be called upon if the buyer fails to meet their contractual obligations. Unlike a commercial letter of credit, which is normally used as the primary payment method for a transaction, an SBLC acts as a backup commitment that can be used if the applicant fails to meet its obligations.

Businesses may use SBLCs to give assurance to suppliers, support contractual obligations, or meet financial security requirements.

Read our complete guide to standby letters of credit (SBLC).

Revolving letter of credit

A revolving letter of credit allows the buyer and seller to reuse the same credit facility for multiple transactions over an agreed period. This can be useful if your business trades regularly with the same supplier or customer, as it removes the need to arrange a new letter of credit for every transaction.

The terms of the agreement determine how often the letter of credit can be renewed and the maximum amount available.

Confirmed letter of credit

A confirmed letter of credit involves an additional bank, known as the confirming bank, which adds its own guarantee to the payment commitment made by the issuing bank.

This provides the seller with an extra layer of security, which can be useful when trading with customers in countries where there is greater political, economic, or banking risk.

Transferable letter of credit

A transferable letter of credit allows the original beneficiary (usually a seller or intermediary) to transfer some or all the credit to another party. This is often used in transactions involving intermediaries, such as trading companies that purchase goods from one supplier and sell them to another customer.

The transfer must be permitted under the terms of the original letter of credit and is subject to specific conditions.

Irrevocable letter of credit

An irrevocable letter of credit cannot be cancelled or significantly amended without agreement from all parties involved. This provides greater certainty for both buyers and sellers because the terms cannot be changed without approval.

Most commercial letters of credit are structured as irrevocable commitments, as this gives greater certainty to both parties.

Although letters of credit and bank guarantees both involve a bank providing financial support, they are used in different cases.

A letter of credit is primarily a payment mechanism, providing a commitment from the issuing bank to pay the seller once the terms of the agreement and required documentation have been fulfilled. Letters of credit are commonly used in international trade to reduce payment risk between buyers and sellers.

A bank guarantee, on the other hand, aims to protect against a side failing to meet its contractual or financial obligations. The bank agrees to compensate the beneficiary if the applicant does not fulfil their obligations.

Banks charge a fee for issuing a letter of credit and usually require a margin amount (cash or securities) as collateral. The amount varies according to several factors, including the company’s credit score, transaction history, and how well-established the company is. The level of collateral or security required often depends on factors such as the buyer’s financial position, relationship with the bank, and the level of risk involved.

Remember that a letter of credit usually covers only one transaction at a time, which means a new letter of credit may be needed for each transaction or trading period. Even when it’s your customer who provides the letter of credit, you still have to ensure everything is in order and then wait for the bank to render a decision and issue the letter of credit.

So, the letter of credit cost in terms of the time and money your company will spend is something you must consider if you’re thinking about ways to secure your transactions.

Imagine a UK-based clothing retailer agrees to buy £50,000 worth of fabric from a manufacturer based in Vietnam. Because this is a new trading relationship, the manufacturer wants payment security before shipping the goods.

The retailer applies to their bank for a letter of credit, submitting the relevant documentation and transaction details. Once the bank approves the arrangement, it issues the LC to the manufacturer's advising bank.

The manufacturer ships the goods and presents the required documents — including a commercial invoice, bill of lading, and packing list — to the bank. Once the documents check out against the LC terms, the payment guarantee kicks in and the bank pays the manufacturer. The retailer then settles the amount with their bank.

This single-transaction structure means a new LC would be needed for each future order.

A letter of credit can help your business reduce exposure to non-payment risk in several ways. The key benefits of using a letter of credit include:

• Reduction in payment risk for sellers: A letter of credit provides the seller with a payment commitment from the issuing bank, if the agreed terms and documentation requirements are met. This can reduce reliance on the buyer’s ability or willingness to pay and provide greater certainty when completing a transaction.
• Trust built between trading partners: For buyers and sellers who do not have an established relationship, a letter of credit can help build confidence. The buyer demonstrates their commitment to completing the transaction, while the seller is reassured that payment is supported by a bank or lender.
• Cash flow management support: As payment is backed by a bank commitment, a letter of credit may help sellers access finance more easily. In some cases, your business can use the strength of the bank’s payment undertaking to support lending arrangements or improve access to working capital.
• International trade made easier: Letters of credit are commonly used in cross-border transactions because they provide a structured model for completing payments. They help businesses manage the risks associated with trading internationally as they set clear terms and documentation requirements.

However, a letter of credit may not always be the most flexible or cost-effective solution if your business manages ongoing trade relationships. Let’s look at some of the limitations of a letter of credit:

• Often limited to individual transactions: A letter of credit is normally arranged for a specific transaction, customer, or agreed period. If your business trades regularly, you may need to establish separate letters of credit for multiple transactions, which can mean more administration and reduce flexibility.
• Can involve costs and administration: Banks and lenders can often charge fees to set up a letter of credit, and the process can also involve documentation requirements and ongoing management. You may also need to think about the impact on your working capital and available credit facilities, as banks may ask for security or collateral before issuing a letter of credit.
• May require additional collateral or security: To issue a letter of credit, a bank may assess the buyer’s financial position and require additional security arrangements. These requirements can affect a company’s borrowing capacity and the amount of capital available for other business activities.
• Payment depends on meeting strict documentation requirements: Unlike some forms of payment protection, a letter of credit operates based on compliance with agreed terms and documentation. If the necessary documents are incomplete, inaccurate, or do not meet the conditions set out in the letter of credit, payment may be delayed while issues are resolved.

If your business trades with multiple customers or seeks ongoing protection against payment risk, alternatives such as trade credit insurance may provide a better approach as they cover a broader customer portfolio and help your business manage credit risk over time.

Both letters of credit and trade credit insurance can help businesses manage payment risk, but they provide protection in different ways.

• A letter of credit provides security for a specific transaction by requiring a bank to make payment if the agreed terms and documentation requirements are met. It is often used in international trade where businesses want additional security when working with new customers, unfamiliar markets, or higher-value transactions.
• Trade credit insurance, also known as accounts receivable insurance, provides ongoing protection against customer non-payment. Often described as ‘bad debt insurance’, it helps businesses protect their cash flow if a customer fails to pay or experiences prolonged payment delays. Trade credit insurance helps your business manage the impact of unexpected events by covering a proportion of insured receivables. It is designed to help you manage insolvency risk by protecting against losses caused by customer non-payment.

The right choice depends on factors such as the type of transaction, the level of risk involved, and whether your business needs protection for a single trade agreement or ongoing support managing customer credit risk.

Here’s a quick table of comparison for your reference:

Trade credit insurance may be more suitable than a letter of credit when:

1. You trade with multiple customers: If your business sells to a broad customer base, arranging separate letters of credit for each transaction may become time-consuming and difficult to manage. Trade credit insurance can give you protection across multiple customers, which helps your business take a more reliable approach to managing payment risk.
2. You offer customers credit terms: Many businesses provide customers with payment terms as part of their normal trading relationships. Trade credit insurance allows companies to offer credit with peace of mind, as they know they have protection if a customer fails to pay due to insolvency or there are payment delays.
3. You want to protect against customer insolvency risk: A letter of credit gives you payment assurance when its conditions are met, but trade credit insurance focuses on protecting businesses against the more general risk of customer default. This can be really important when economic conditions are uncertain or when customers operate in markets with higher levels of commercial risk.
4. You want greater visibility over customer risk: Trade credit insurance providers use credit risk expertise and market insight to help businesses assess the financial strength of customers and monitor changes in their risk profile. This can help finance teams make more better choices about who they trade with and the credit terms they offer.
5. You are looking for a long-term credit management solution: For businesses focused on sustainable growth, managing customer credit risk is an ongoing process rather than a one-off transaction. Trade credit insurance can form part of your general credit management strategy and can help your business businesses protect cash flow while continuing to build customer relationships.

Deciding between a letter of credit and trade credit insurance depends on your business needs, customer relationships, and approach to managing payment risk.

A letter of credit can give you the security you need for individual transactions, especially when you trade internationally or work with new customers. However, businesses looking to protect ongoing customer relationships, manage wider credit risk, and take care of their receivables may benefit from a more comprehensive approach.

Trade credit insurance from Allianz Trade helps your business protect against the impact of customer non-payment, including insolvency, and payment delays. But Allianz Trade also gives you market insight through our global network of experienced risk analysts and finance professionals. Our experts monitor current and potential customers to help your business understand changing risks and make the right decisions.

With access to market intelligence and customer risk assessments, your business can manage credit terms, protect cash flow, and detect opportunities for sustainable growth.
To learn more about how Allianz Trade can support your credit decisions and help protect your business against late or non-payment, contact our local teams today.