1 Overview
A letter of credit is a bank's written promise to pay a seller a specified amount, provided the seller presents documents that strictly comply with the L/C terms. It is not a payment method in the sense of cash or card; it is a documentary undertaking that substitutes bank credit for the buyer's credit. The buyer's bank issues the L/C, the seller's bank advises it, and payment is triggered by documents, not by the goods themselves. This makes the L/C a risk-splitting tool: the seller gains assurance of payment if it ships and presents compliant papers, while the buyer gains assurance that payment only occurs against documents that evidence shipment.
Because banks deal in documents, not cargo, the L/C is governed by rules such as the Uniform Customs and Practice for Documentary Credits. These rules define what counts as a complying presentation and how banks examine documents. The L/C is separate from the underlying sales contract; banks are not concerned with the quality of the goods or whether the buyer is happy with them. Their obligation is to check documents against the L/C terms. That separation is both the strength and the vulnerability of the instrument: it gives certainty, but it also means a small typo can turn a compliant presentation into a discrepancy.
2 Where the risk and the cost actually land
Risk in an L/C transaction is split between payment risk and performance risk. Payment risk shifts from the seller to the issuing bank once the seller presents complying documents. If the buyer becomes insolvent or refuses to pay, the bank must still honor the L/C, assuming the documents are clean. Performance risk, however, remains with the buyer: the bank does not guarantee that the goods are as described or that they will arrive. The buyer's protection comes from the documents required, such as a transport document showing shipment, an inspection certificate, or an insurance policy. If the L/C is silent on quality, the buyer bears the risk that the goods are defective.
Costs follow the L/C terms and the sales contract. The buyer typically pays the issuing bank's fees, while the seller pays the advising bank and any negotiation or discrepancy fees. Freight, insurance, and duty costs are not determined by the L/C itself but by the Incoterm in the sales contract. For example, under CIF or CIP, the seller arranges and pays freight and insurance to a named destination; under FOB or FCA, the buyer arranges and pays the main carriage. The L/C may require the seller to present an insurance certificate, but the obligation to insure comes from the Incoterm or the contract, not from the L/C alone. In air freight, the same logic applies, though the transport document is an air waybill rather than a bill of lading.
3 How the mechanics work end to end
The process begins with a sales contract that specifies an L/C as the payment method. The buyer applies to its bank for an L/C in favor of the seller. The issuing bank sends the L/C to a bank in the seller's country, which advises the seller. The seller reviews the L/C carefully, because it must be able to produce every required document exactly as specified. If the terms are impossible or inconsistent, the seller should request an amendment before shipping.
After shipping, the seller assembles the documents: commercial invoice, transport document, packing list, certificate of origin, insurance certificate if required, and any inspection or quality certificates. These are presented to the advising or negotiating bank within the L/C's validity and presentation period. The bank examines the documents against the L/C terms. If they comply, the bank pays the seller or forwards the documents to the issuing bank for reimbursement. If there are discrepancies, the bank may refuse to pay until the buyer waives them or the seller corrects them. Once the issuing bank receives and accepts the documents, it releases payment to the seller's bank and releases the documents to the buyer, who uses them to claim the goods from the carrier. The entire chain depends on documentary precision, not on the goods themselves.
4 A worked example from door to destination
Imagine a seller in Country A agrees to sell machinery to a buyer in Country B for air shipment. The sales contract is CIF Destination Airport, and payment is by an irrevocable L/C at sight. The buyer's bank issues the L/C, requiring an air waybill consigned to the issuing bank, a commercial invoice, a packing list, a certificate of origin, and an insurance certificate for 110 percent of the invoice value. The seller books the air freight, arranges insurance, and ships the machinery. The air waybill shows the airport of departure and destination, and the goods are consigned to the bank, not directly to the buyer.
The seller presents the documents to its bank. The bank checks them and finds that the insurance certificate states 100 percent of invoice value instead of 110 percent. That is a discrepancy. The seller must either obtain a corrected certificate or ask the buyer to waive the discrepancy. If the buyer waives it, the issuing bank pays. If not, the seller may need to amend the L/C or accept payment outside the L/C, losing the bank's payment guarantee. Once the documents are compliant, the issuing bank pays the seller's bank and releases the air waybill to the buyer. The buyer uses the air waybill to collect the goods at the destination airport, pays any duty and taxes, and takes delivery. The L/C has done its job: the seller got paid against documents, and the buyer got title to the goods only after payment.
5 Mistakes that cost money at the border
The most common and expensive mistake is treating the L/C as a mere formality and shipping before checking every required document. A missing certificate, a misspelled name, or a date that falls outside the allowed period can create a discrepancy. Banks are strict: they must refuse documents that do not comply, even if the discrepancy seems trivial. Another frequent error is misunderstanding the transport document requirements. In air freight, the L/C may require an air waybill consigned to a specific party or showing a particular airport of departure. If the air waybill is consigned to the buyer instead of the bank, the bank loses control over the goods, and the seller may not get paid.
A second costly mistake is ignoring the Incoterm when arranging insurance and freight. If the L/C requires an insurance certificate but the seller ships under FCA, the seller may not be obligated to insure, yet the L/C demands it. The seller must then buy insurance anyway or face a discrepancy. Similarly, if the L/C calls for a full set of bills of lading but the shipment moves by air, the seller cannot produce a bill of lading. The documents must match the mode of transport. Finally, failing to present documents within the L/C's validity or presentation period can void the bank's payment obligation. Even if the goods arrived safely, late presentation can leave the seller unpaid or forced to rely on the buyer's goodwill.
6 Documents worth keeping
The documents required by an L/C are the backbone of the transaction, and each one serves a specific purpose. The commercial invoice identifies the goods, the parties, and the amount due. The transport document, such as an air waybill or bill of lading, proves that the goods were shipped and often serves as a document of title or a contract of carriage. The packing list details the contents of each package, which helps customs and the buyer verify the shipment. The certificate of origin declares where the goods were produced, which can affect duty rates under trade agreements. The insurance certificate or policy proves that the goods are covered against loss or damage during transit, as required by the L/C or the Incoterm.
Beyond the core set, an L/C may require an inspection certificate from a nominated inspection company, a quality certificate, or a beneficiary's certificate. These documents shift certain risks back to the seller or provide the buyer with assurance. It is wise to keep copies of every document presented, along with the bank's advice and any amendments. If a dispute arises, the paper trail shows what was required and what was presented. In air freight, the air waybill is particularly important because it is non-negotiable and consigns the goods to a named party. Keeping the full set of documents, including the L/C itself and all correspondence, helps resolve discrepancies and supports any claim for payment or reimbursement.
7 Frequently asked questions
What is the difference between an L/C and a documentary collection? In a documentary collection, banks act as intermediaries but do not guarantee payment. The seller ships and sends documents through banks to the buyer, who pays or accepts a draft to obtain the documents. In an L/C, the bank promises to pay if the documents comply, so the seller has a bank's credit rather than the buyer's. A documentary collection is cheaper but riskier for the seller; an L/C is more expensive but safer.
Can an L/C be used for air freight? Yes. The L/C rules apply to any mode of transport. The key is that the required transport document must match the mode. For air freight, the document is an air waybill, which is not a document of title. Banks may still require consignment to the bank to control delivery. The L/C should specify the airport of departure and destination, the latest shipment date, and the presentation period.
What happens if the documents have discrepancies? The bank may refuse to pay until the buyer waives the discrepancies or the seller corrects them. If the buyer refuses to waive, the seller may need to amend the L/C or present new documents. In some cases, the seller can request the issuing bank to pay under reserve or against an indemnity, but that is not a guarantee. The best approach is to check the L/C before shipping and prepare documents with extreme care.