A letter of credit (L/C; Turkish: akreditif) is a payment method in which the buyer's bank gives the seller a written undertaking to pay against the timely presentation of documents complying with the terms of the credit. The bank examines documents, not goods. In international practice it is governed by the ICC's UCP 600 rules and gives the seller a bank guarantee independent of the buyer's ability to pay.
Who are the parties to a letter of credit?
A letter of credit is a bank undertaking separate from and independent of the sales contract. The following parties are usually involved in the transaction:
- Applicant: The buyer, i.e. the importer, who has the credit opened.
- Issuing bank: The buyer's bank, which gives the payment undertaking.
- Beneficiary: The seller, i.e. the exporter, who will receive payment.
- Advising bank: The bank, usually in the seller's country, that checks the authenticity of the credit and notifies the beneficiary.
- Confirming bank: A bank that adds its own payment undertaking to that of the issuing bank.
How does a letter of credit work step by step?
- In the sales contract or proforma invoice, the parties specify that payment will be made by letter of credit, the amount, the latest shipment date and the documents required.
- The buyer applies to its bank; the bank opens the credit against a credit limit or collateral and usually transmits it to the advising bank via a SWIFT MT700 message.
- The advising bank notifies the seller of the credit. The seller reviews the terms immediately; if there is a condition it cannot fulfil, it requests an amendment.
- The seller ships the goods and prepares the document set: commercial invoice, bill of lading or CMR, packing list, insurance certificate, certificate of origin and so on.
- The documents are presented to the bank. Under Article 14 of UCP 600, a presentation including an original transport document must be made no later than 21 calendar days after the date of shipment, and in any case before the credit expires.
- The bank examines the documents for compliance within a maximum of five banking days.
- If the documents comply, payment is made, or in a deferred credit, payment at maturity is undertaken; the buyer takes delivery of the goods with the documents.
What types of letters of credit are there?
| Type | Feature | When is it preferred? |
|---|---|---|
| Irrevocable | Cannot be amended or cancelled without the beneficiary's consent. Under UCP 600, a credit is irrevocable even if not stated. | Standard practice |
| Confirmed | A second bank also undertakes to pay. | If the risk of the issuing bank or its country is high |
| Sight | Paid immediately upon presentation of complying documents. | If the seller wants cash up front |
| Deferred payment | Payment is made at a specified maturity. | Sales where the buyer is given payment terms |
| Transferable | The beneficiary can transfer the credit in whole or in part to a second beneficiary. | Intermediary trade and transit trade |
| Revolving | The amount used is automatically reinstated under certain conditions. | Regular shipments in instalments |
Why is document compliance decisive?
Banks deal with documents, not goods. Even if the goods are defective, the bank pays if the documents appear on their face to comply with the terms of the credit; even if the goods are flawless, it can refuse payment if there are discrepancies in the documents. The most common discrepancies in practice are:
- Shipment after the latest shipment date or presentation later than 21 days,
- A note of damage or deficient packaging on the bill of lading, i.e. the document not being clean,
- The description of goods on the invoice not matching that in the credit,
- Insufficient insurance cover; under UCP 600, unless otherwise stated, cover must be at least 110% of the CIF or CIP value of the goods,
- Weight, number of packages or port name written differently across documents.
For insurance document requirements see the cargo insurance certificate entry, and for the transport document the bill of lading entry.
What is the difference between a letter of credit and documents against payment?
In both methods, the documents pass through banks. The difference lies in the payment undertaking: in a letter of credit, the issuing bank undertakes to pay, whereas in documents against payment the bank is only an intermediary, and if the buyer does not take up the documents, the seller has no bank undertaking. A letter of credit is more secure, but bank charges and the collateral burden are higher.
How does Voltim Global support this?
For shipments under a letter of credit, Voltim Global checks documents before loading so that the transport document is issued in line with the wording, port or place of loading and dates required in the credit. Questions about the document set are handled under regulatory consultancy.