Letter of Credit

💼 Letter of Credit (LC): Meaning, Types, Process & Advantages Explained

A Letter of Credit (LC) is one of the most reliable and widely used financial instruments in international trade. It helps ensure that exporters and importers can conduct transactions with trust and security, even when operating across borders.

In this guide, we’ll explain the meaning of Letter of Credit, its types, process, and advantages — with a simple real-world example.

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🔹 What is a Letter of Credit? (LC Meaning)

A Letter of Credit is a document issued by a bank that guarantees payment to the seller (exporter) on behalf of the buyer (importer), as long as the seller meets the specified terms and submits the required documents.

It acts as a payment assurance mechanism that protects both parties in a trade deal — ensuring that the seller receives payment and the buyer receives the agreed goods or services.

In simple terms:

A Letter of Credit is a bank’s promise to pay the seller once all the trade conditions are met.

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🔹 Key Parties Involved in a Letter of Credit

Every LC transaction involves several key parties:

1. Applicant (Buyer/Importer): The party requesting the LC from their bank.

2. Beneficiary (Seller/Exporter): The party in whose favor the LC is issued.

3. Issuing Bank: The buyer’s bank that issues the Letter of Credit.

4. Advising Bank: The seller’s bank that notifies the seller about the LC.

5. Confirming Bank (optional): A bank that adds its guarantee to the LC, ensuring payment even if the issuing bank fails.

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🔹 Types of Letter of Credit

There are several types of Letters of Credit, depending on the trade needs and risk factors:

1. Revocable LC: Can be amended or canceled at any time without the seller’s consent (rarely used).

2. Irrevocable LC: Cannot be altered or canceled without the consent of all parties — most commonly used in international trade.

3. Confirmed LC: Includes an additional guarantee from a second bank.

4. Sight LC: Payment is made immediately after the documents are verified.

5. Usance (Deferred Payment) LC: Payment is made after a specified period.

6. Standby LC: Works as a backup guarantee in case of non-payment or contract default.

7. Transferable LC: Can be transferred by the original beneficiary to another party (common in intermediary trading).

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🔹 Process of a Letter of Credit (Step-by-Step)

Here’s how the Letter of Credit process typically works:

1. The buyer and seller agree on trade terms and decide to use an LC.

2. The buyer applies for a Letter of Credit from their bank.

3. The issuing bank sends the LC to the advising (seller’s) bank.

4. The seller ships the goods and submits shipping and trade documents to their bank.

5. The advising bank verifies the documents and sends them to the issuing bank.

6. Once verified, the issuing bank releases the payment to the seller.

This process ensures that both parties’ interests are protected.

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🔹 Advantages of a Letter of Credit

Using an LC offers several benefits for both exporters and importers:

✅ Assured Payment: The seller is guaranteed payment once LC conditions are met.
✅ Reduced Risk: Protects both buyer and seller from non-payment or non-delivery.
✅ Trust in International Trade: Encourages global trade between new partners.
✅ Access to Financing: Sellers can use LCs as collateral to secure loans.
✅ Customizable Terms: LCs can be tailored to fit specific trade agreements.

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🔹 Example of a Letter of Credit

Let’s look at a simple example:

An Indian importer agrees to purchase machinery from a German exporter. To build trust, the importer’s bank issues a Letter of Credit guaranteeing payment once the exporter provides shipping documents, an invoice, and a bill of lading.

After verification, the bank releases the payment to the exporter — ensuring a smooth, secure transaction for both sides.