Letter of credit

What it means

A letter of credit solves the basic problem of a first deal: the seller will not ship without money, the buyer will not pay without goods. The bank steps in and pays against documents.

The bank judges paperwork, not goods: the invoice, the transport document, insurance, a certificate of origin. If the documents match the credit exactly it pays; if they differ in any detail it does not.

A letter of credit is often confused with a bank guarantee. Under a letter of credit the bank pays when the deal went to plan and the seller presents the documents. Under a guarantee it pays when something failed and the beneficiary makes a claim. The letter of credit is a way of paying; the guarantee is cover for the case that one side does not perform.

How it works in practice

It is used on imports and exports outside the EU, particularly with new partners and larger amounts. The credit terms must line up with the Incoterms rule, or the documents cannot be presented in time.

In the books it shows as restricted cash or an advance to the bank, not as an expense. Bank charges go to financial costs and on larger deals they are not trivial.

On a client’s export we check before the goods leave that the details on the invoice match the wording of the credit letter for letter: the buyer’s name and address, the description of goods, currency, amount and delivery term. We prepare the invoice exactly as the credit reads, even when the wording looks odd, because the bank compares text, not the substance of the deal.

What to watch out for

Most disputes come from document discrepancies: a different product name, a different shipment date, a missing stamp. The bank then holds payment although the goods arrived weeks ago, and an amendment costs a fee.

The second risk is the buyer’s bank itself. A letter of credit protects only as far as the issuing bank is able and willing to pay, and for a bank in a risky country that may not be far. On larger deals a confirmed credit is therefore requested, backed by the seller’s bank as well. Without confirmation the seller carries the foreign bank and country risk while believing the money is safe.