How A Letter Of Credit Works Step By Step For Importers And Exporters

That distinction is the starting point for understanding how letters of credit actually work. A documentary credit is not a vague comfort letter, and it is not the same as open-account trade. It is a structured instrument governed by its wording, the underlying banking rules, and the quality of the document presentation.

For importers, the letter of credit helps control when payment is triggered. For exporters, it reduces the risk of shipping goods without a bank-backed path to settlement. For both sides, it creates discipline, but only if the credit is drafted properly and the documents can actually be produced in the form the banks require.

Step 1: Buyer And Seller Agree The Commercial Terms

The process starts with the sales contract. The parties agree the product, quantity, price, shipment period, Incoterms, and payment method. If payment is to be made by letter of credit, that should be stated clearly in the contract together with the basic expectations around timing, type of credit, and required documents.

This stage is more important than many businesses admit. If the contract is vague, the credit will often inherit that vagueness, and the documentary problems begin before the bank is even involved.

Step 2: The Buyer Applies For The Letter Of Credit

The importer, also called the applicant, asks its bank to issue the letter of credit in favour of the exporter, who becomes the beneficiary. The issuing bank does not simply issue because the buyer asks. It reviews the applicant, the transaction, the requested amount, the tenor, and the documentary conditions.

Step 3: The Issuing Bank Sends The Credit Through The Banking Chain

Once approved, the issuing bank transmits the documentary credit through the banking system, usually by SWIFT. The advising bank receives and authenticates the credit before advising it to the beneficiary. If the credit is confirmed, a confirming bank may add its own undertaking as well.

This stage is often described as routine, but it is where the formal instrument becomes real. The message that typically carries the original issuance terms is the MT700. The seller should read the actual credit wording, not just rely on what the buyer said was requested.

Step 4: The Seller Reviews The Credit Carefully

This is where disciplined exporters separate themselves from sloppy ones. The beneficiary should not begin shipment blindly. The credit must be checked against the sales contract, logistics reality, insurance arrangements, inspection obligations, and the actual documents that can be produced.

Step 5: Goods Are Shipped Or Services Are Performed

Once the seller is satisfied with the credit, the commercial performance begins. Goods are shipped, transport documents are generated, insurance is placed if required, and the other commercial documents begin to take shape.

At this point, the seller should already be working backwards from the presentation requirements. Document problems are much easier to prevent before shipment than to repair afterwards.

Step 6: The Beneficiary Presents Documents

After shipment or other required performance, the beneficiary presents the documents required under the credit. Depending on the structure, these may include the commercial invoice, bill of lading or airway bill, packing list, certificate of origin, insurance document, inspection certificate, or other specified papers.

Step 7: The Bank Examines The Presentation

The presenting bank, nominated bank, or issuing bank examines the documents under the terms of the credit and applicable rules. Under modern documentary credit practice, the key question is whether the documents appear compliant on their face. Banks are not checking whether the cargo was economically attractive or whether the buyer later regrets the trade.

If the documents comply, the bank honours, accepts, or negotiates according to the credit structure. If discrepancies exist, the bank may refuse the presentation, hold the documents pending waiver, or otherwise complicate the payment path.

Step 8: Payment Happens According To The Credit Terms

If the credit is payable at sight, payment usually follows once the presentation is found compliant and the relevant bank honours. If it is a deferred payment or usance structure, payment happens later at maturity. In those cases, the exporter may look at discounting if immediate liquidity is needed.

Why Letters Of Credit Still Matter

Letters of credit remain relevant because international trade still contains trust gaps, jurisdiction gaps, and payment risk. Open account terms work when counterparties know each other well and balance sheets are strong. Documentary credits exist for the deals where that comfort does not yet exist or where the parties want bank-backed control.

They are especially useful in import-export transactions, commodity flows, distribution contracts, and first-time cross-border relationships where the seller wants more than a promise and the buyer wants documentary control before payment is released.

Where LC Transactions Usually Go Wrong

Where Financely Fits

For many clients, the challenge is not simply getting an LC issued. The real issue is making sure the credit is commercially usable, the wording aligns with the transaction, and the broader funding path still works once shipment and payment timing are taken into account.

That is why LC transactions often overlap with broader trade finance structuring and asset-based lending and underwriting , particularly where supplier payment, receivables timing, or inventory funding sit alongside the documentary credit.

Frequently Asked Questions