What is A Letter of Credit?

A Letter of Credit (LC) in the UK context is a financial instrument used primarily in international trade transactions to facilitate secure payments between a buyer and a seller. Here’s an explanation tailored for a UK audience:


  1. Definition:
    • A Letter of Credit is a document issued by a bank on behalf of a buyer (importer) to guarantee payment to a seller (exporter) once specified conditions are met. It serves as a commitment from the bank to make a payment to the seller upon presentation of compliant documents.
  2. Purpose:
    • Risk Mitigation: Provides assurance to both the buyer and seller by reducing payment risk. The seller is assured of payment as long as the terms of the LC are fulfilled, while the buyer ensures that payment is made only when goods are received as per agreed terms.
    • International Trade Facilitation: LCs are commonly used in cross-border transactions where the parties may not have established trust or where there are concerns about political or economic stability.
  3. Key Components:
    • Issuing Bank: The bank that issues the LC on behalf of the buyer, undertaking to pay the seller upon presentation of compliant documents.
    • Beneficiary: The seller or exporter who will receive payment under the LC once they fulfill the terms and conditions.
    • Applicant: The buyer or importer who requests the LC to facilitate the transaction.
    • Terms and Conditions: Specifies the documents required (e.g., invoice, bill of lading) and the conditions under which payment will be made (e.g., shipment date, inspection certificates).
  4. Types of Letters of Credit:
    • Irrevocable LC: Cannot be modified or canceled without the consent of all parties involved.
    • Revocable LC: Can be modified or canceled by the issuing bank without prior notice to the beneficiary (less commonly used due to its lack of security for the beneficiary).
  5. Process:
    • Issuance: The buyer arranges with their bank to issue an LC in favor of the seller, specifying the terms and conditions of payment.
    • Presentation: The seller ships the goods and presents the required documents (e.g., shipping documents, commercial invoice) to their bank.
    • Payment: Upon verification that the documents comply with the LC terms, the issuing bank makes payment to the seller or their bank.
  6. Benefits:
    • Payment Security: Provides assurance to the seller that they will receive payment upon fulfilling the terms of the LC.
    • Trade Facilitation: Facilitates smoother international trade transactions by reducing payment risk and improving trust between parties.
    • Credit Enhancement: Allows the buyer to negotiate better terms with the seller by demonstrating their creditworthiness through the LC.

In summary, a Letter of Credit is a crucial tool in international trade for UK businesses, providing a secure method of payment and facilitating transactions where trust and payment risks are significant concerns. It helps ensure that both importers and exporters can engage in trade transactions with confidence, even across different countries and currencies.