Letters of Credit (L/Cs) are the backbone of international commodity trade. They provide payment security for sellers while giving buyers confidence that they’ll receive the goods they paid for.
What is a Letter of Credit?
Definition
A Letter of Credit is a bank’s written commitment to pay a specified amount to a beneficiary (seller) upon presentation of conforming documents.
L/C MECHANISM
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PARTIES:
Applicant: Buyer (requests L/C)
Issuing Bank: Buyer's bank (issues L/C, guarantees payment)
Beneficiary: Seller (receives payment)
Advising Bank: Seller's bank (advises, may confirm)
FLOW:
1. Buyer applies to Issuing Bank
2. Issuing Bank issues L/C
3. Advising Bank notifies Seller
4. Seller ships goods
5. Seller presents documents to bank
6. Bank pays if documents conform
Why L/Cs Exist
Risk
Without L/C
With L/C
Buyer doesn’t pay
Seller exposed
Bank pays
Seller doesn’t ship
Buyer exposed
No payment without docs
Different countries
Enforcement difficult
Bank intermediation
Unknown counterparty
Trust issue
Bank credibility
Types of L/Cs
By Payment Timing
Type
Payment Timing
Use Case
At sight
Immediate on doc presentation
Standard trade
Usance/deferred
30-180 days after sight
Extended terms
Acceptance
Pay on maturity of draft
Term financing
By Security Level
Type
Confirmation
Security Level
Unconfirmed
Issuing bank only
Issuing bank risk
Confirmed
Advising bank adds guarantee
Two bank guarantee
Standby
Backup payment
Default coverage
Irrevocable vs Revocable
IRREVOCABLE L/C (Standard)
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Cannot be amended or cancelled without
consent of ALL parties (beneficiary, issuing bank, confirming bank)
PROVIDES:
- Certainty of payment
- Seller protection
- Bank commitment
ALL MODERN L/Cs ARE IRREVOCABLE
(Revocable L/Cs are obsolete)
L/C Process Flow
Step-by-Step
L/C LIFECYCLE
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STAGE 1: ISSUANCE
Day 0: Buyer/Seller agree L/C terms in contract
Day 1: Buyer applies to Issuing Bank
Day 2: Issuing Bank opens L/C
Day 3: L/C transmitted to Advising Bank (SWIFT)
Day 4: Advising Bank authenticates, advises Seller
STAGE 2: UTILIZATION
Day 10: Seller ships goods
Day 12: Seller prepares documents
Day 15: Seller presents docs to Advising Bank
Day 16: Advising Bank checks documents
Day 17: Documents sent to Issuing Bank
Day 20: Issuing Bank examines (5 banking days)
Day 25: If compliant → Payment
STAGE 3: SETTLEMENT
Day 25: Issuing Bank pays Advising Bank
Day 25: Advising Bank credits Seller
Day 25: Buyer reimburses Issuing Bank
Day 25: Documents released to Buyer
Document Requirements
Typical Document Set
Document
Purpose
Who Issues
Commercial Invoice
Specifies goods, price
Seller
Bill of Lading
Transport document, title
Carrier
Certificate of Origin
Country of origin
Chamber of Commerce
Certificate of Quality
Specifications
Independent surveyor
Certificate of Quantity
Weights/volumes
Independent surveyor
Insurance Certificate
Coverage proof
Insurer
Packing List
Contents details
Seller
Document Standards
DOCUMENT REQUIREMENTS (UCP 600)
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INVOICE:
- Goods description matches L/C exactly
- Amount does not exceed L/C
- Currency matches
- Signed (if required)
BILL OF LADING:
- Shows cargo on board
- Clean (no damage clauses)
- Dated within shipment period
- Correct ports
- Correct quantity
CERTIFICATES:
- Issued by party specified in L/C
- Data matches other documents
- Dated appropriately
Document Discrepancies
Common Discrepancies
Discrepancy
Example
Severity
Quantity mismatch
Invoice 25,000 MT, B/L 24,950 MT
Medium
Late shipment
L/C requires by May 15, B/L dated May 17
Major
Port name wrong
”Singapore” vs “Port of Singapore”
Minor
Description mismatch
”Crude Oil” vs “Bonny Light Crude Oil”
Medium
Missing document
Insurance cert not presented
Major
Handling Discrepancies
DISCREPANCY RESOLUTION
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OPTION 1: AMEND L/C
- Request amendment from buyer
- Bank issues amended L/C
- Re-present documents
TIME: 3-7 days
OPTION 2: SEEK WAIVER
- Ask buyer to accept discrepancy
- Bank accepts on waiver
- Payment proceeds
TIME: 1-3 days
OPTION 3: CORRECT DOCUMENTS
- If possible, get corrected docs
- Re-present
TIME: Varies
OPTION 4: COLLECTION BASIS
- Withdraw from L/C
- Present docs for collection only
- Loses bank guarantee
RISK: Buyer may not pay
Discrepancy Rates
INDUSTRY STATISTICS
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First presentation rejection rate: 60-75%
(Most docs have some discrepancy)
Common causes:
- Human error in preparation
- Rushing to meet deadlines
- Complex requirements
- Multiple parties involved
COST OF DISCREPANCY:
Amendment fee: $100-300
Delay: 3-7 days
Interest cost: Significant
Reputation: Damaged
SOLUTION: Careful document preparation
L/C Costs
Fee Structure
L/C COST BREAKDOWN
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ISSUING BANK FEES:
Issuance fee: 0.1-0.5% (one-time)
Usance fee: 0.5-2.0% p.a. (if deferred)
Amendment fee: $50-200 (per amendment)
ADVISING BANK FEES:
Advising fee: $50-200 (flat)
Confirmation fee: 0.5-3.0% p.a. (if confirmed)
Negotiation fee: 0.1-0.25%
OTHER COSTS:
SWIFT charges: $50-100
Courier: $50-100
EXAMPLE (Sight L/C, $100M):
Issuance: 0.2% = $200,000
Advising: $100
Negotiation: 0.1% = $100,000
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Total: ~$300,000 (0.3% of value)
Cost Comparison
Method
Cost
Security
Advance payment
0%
Buyer bears all risk
L/C at sight
0.2-0.5%
Balanced
Confirmed L/C
0.5-1.5%
Seller very secure
Usance L/C
1-3%
Buyer gets terms
Open account
0%
Seller bears all risk
UCP 600
The Governing Rules
UCP 600 (Uniform Customs and Practice)
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Published by: International Chamber of Commerce
Effective: July 2007
Applies: When L/C states "subject to UCP 600"
KEY ARTICLES:
Article 14: Document examination
- Banks have 5 banking days to examine
- Must decide: compliant or refuse
Article 15: Compliant presentation
- Bank must honor if docs comply
- No discretion
Article 16: Discrepant documents
- Must give single notice
- Must state all discrepancies
- Must state disposition
Article 17: Original documents
- One original of each required
- Unless otherwise stated
Article 19-27: Transport documents
- Specific requirements for B/L, air waybill, etc.
Standby Letters of Credit
Purpose
STANDBY L/C vs DOCUMENTARY L/C
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DOCUMENTARY L/C:
Primary payment mechanism
Drawn upon when seller performs
STANDBY L/C:
Secondary/backup mechanism
Drawn upon when buyer FAILS to perform
USE CASES:
- Performance guarantee
- Payment guarantee
- Bid bond
- Advance payment guarantee
EXAMPLE:
Buyer agrees to pay on open account
Standby L/C backs up payment
If buyer doesn't pay → draw on standby
Electronic L/Cs
Digital Transformation
TRADITIONAL vs ELECTRONIC
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TRADITIONAL:
- Paper documents
- Physical courier
- Days for transmission
- Manual checking
ELECTRONIC (emerging):
- Digital documents
- Electronic transmission
- Minutes for transmission
- Automated checking
PLATFORMS:
- Marco Polo
- Contour
- Voltron
- TradeLens (for B/L)
BENEFITS:
- Speed: Days → Hours
- Cost: 50-80% reduction
- Errors: Reduced
- Fraud: Harder to forge
Key Takeaways
L/Cs provide payment security — Bank guarantee for both parties
Documents must be perfect — 60-75% first presentation rejection
UCP 600 governs — Know the rules
Costs are significant — 0.2-3% of trade value
Confirmation adds security — Second bank guarantee