How To Use Letters of Credit?

When trust is low and stakes are high, a Letter of Credit steps in. It shifts payment risk from parties into a bank’s hands. Buyers tap LCs to guarantee suppliers get paid. Sellers lean on LCs to ensure they don’t ship goods for nothing. Below, we’ll walk through key LC types and show how businesses deploy them in real deals. For related bank instruments, visit our Bank Instruments page.

Collateralized vs. Undercollateralized Letters of Credit

A collateralized LC demands the applicant lodge full security—cash, term deposit or marketable securities—equal to the LC’s face value. That collateral locks the bank’s risk in. Fees stay low. Corporates with limited credit turn to this to secure LCs at favorable rates. The bank holds collateral until expiry or full discharge.

An undercollateralized LC asks for only partial security. The bank backstops the balance with its credit line. Fees climb to cover extra exposure. Firms with solid credit ratings tap undercollateralized LCs to preserve working capital. They post minimal collateral and still secure seller commitments.

Financial (Standby) Letters of Credit

Financial LCs stand guard over payment obligations in non‑trade contexts. They trigger only if the applicant fails to pay or perform. Rent, lease or service contracts often carry standby LCs. The beneficiary draws up to the LC amount. Banks issue these as insurance without paperwork hassles tied to trade LCs.

In project finance, standby LCs support bonds and guarantees between carriers and charterers. They insure performance or indemnify cargo claims. The bank pays under the LC then pursues recovery from the applicant.

Performance Letters of Credit

Performance LCs sit alongside contracts for construction, engineering or supply projects. Developers require a guarantee—often five to ten percent of contract value—before work starts. If the contractor misses milestones or quality thresholds, the sponsor draws to cover completion costs. That keeps contractors focused on delivery.

Usance Letters of Credit

With a usance LC, payment defers 30, 60 or 90 days after document presentation. The issuing bank still guarantees funds, but on credit terms. Sellers trust the guarantee. They discount drafts at their bank for immediate cash. Buyers match payment timing to inventory turnover or sales cycles. Traders in commodities and consumer goods especially prize usance LCs for working capital relief.

Bank Guarantees vs. Letters of Credit

A bank guarantee mirrors an LC’s promise but skips rigid document checks. It kicks in only on default. Buyers use advance payment guarantees when they pay ahead of shipment. Contractors issue bid bonds with bank guarantees to secure tenders. Guarantees require the applicant to cure defaults within grace periods or face immediate payout by the bank.

Step‑by‑Step: Deploying a Letter of Credit

Negotiation and Terms

Buyer and seller agree on price, delivery, insurance, and the documents an LC must cover. Precision matters. One mismatch and the bank flags a discrepancy.

Application and Credit Assessment

The buyer applies at their bank. They supply the sale contract, pro forma invoice and any credit support. The bank reviews credit, sets collateral needs and quotes fees.

Issuance and Advising

The issuing bank sends the LC to an advising bank in the seller’s market. The adviser verifies authenticity and forwards it. Sellers may insist on confirmation for extra security.

Shipment and Document Presentation

Seller ships goods, gathers original documents—bill of lading, invoice, packing list, insurance certificate and any inspection report. They lodge documents at the advising bank before LC expiry.

Document Review and Payment

Banks scrutinize every detail. On sight LCs, they pay immediately when compliant. With usance, they accept a time draft and pay on maturity. Sellers often discount drafts for cash ahead of date.

Reimbursement and Settlement

The issuing bank debits the buyer’s account or seizes collateral. Payment disputes over quality or timing must head to arbitration. The LC stays out of product disputes.

Cost and Timing Considerations

Issuing fees range from 0.5–1.5% of LC value. Advising adds 0.1–0.3%. Confirmation can tack on 0.5–1%. Collateral cuts fees roughly in half. Undersecured LCs climb above 2% when credit stretches. Issuance takes one to three days with clean docs. Presentation and payment wrap in two to five days unless deferred.

Common Risks and Pitfalls

The biggest killer is mismatched documents. Sellers must vet every entry, date and stamp. Discrepancies force corrections or buyer approvals. Fraud also looms. Banks guard against bogus collateral and doctored documents with strict KYC and vetted correspondents.

Real‑World Example

A machinery importer orders equipment from Korea. They negotiate a 60‑day usance LC. The Korean supplier ships, presents documents and draws a 60‑day draft. They discount at 97% face value to get cash now. The importer pays on day 60. Both sides manage cash flow and risk without sweating upfront payment.