Letter of Credit (LC) for Exporters and Importers — How It Works, the Four Parties, Documents, Types, Costs and What Happens on Default
Video Explanation & Insights
Letter of Credit: how it protects both the exporter and the importer
3 videos on this topic
The problem an LC solves
In an export deal each side fears the other. The importer worries about paying for goods that never arrive or arrive wrong; the exporter worries about shipping goods and never being paid. Payment terms try to allocate that risk — advance payment protects the exporter, documents against payment or acceptance sits in the middle — but a Letter of Credit removes it by substituting a bank's promise for the buyer's. The issuing bank undertakes to pay the exporter when documents proving shipment as per the agreed terms are presented; a bank defaults only in the most abnormal conditions, which is why an LC is the most trusted term in trade.
| Party | Role in the video's example |
|---|---|
| Exporter (beneficiary) | Piyush in Jaipur, shipping textiles worth USD 1 lakh |
| Importer (applicant) | Mr John in the USA, who asks his bank to open the LC |
| Issuing bank | John's bank (Citi in the example) — issues the LC and carries the payment undertaking; takes collateral or margin from John |
| Advising / negotiating bank | The exporter's bank in India (SBI in the example) — checks the LC, advises it to the exporter, examines documents and collects payment |
From sales contract to payment
- 1Step 1 — Sales contract: quantity, specification, price basis (FOB / CIF), shipment date, port, payment 'by irrevocable LC at sight' and the documents to be presented.
- 2Step 2 — The importer applies to the issuing bank with the contract; the bank fixes the LC terms, takes its margin or collateral, and issues the LC (SWIFT MT700).
- 3Step 3 — The LC reaches the exporter's bank, which verifies the issuing bank's authenticity and credit standing, and advises the LC to the exporter. Read every clause now — this is the moment to ask for amendments.
- 4Step 4 — The exporter ships within the LC period and assembles the documents: commercial invoice, packing list, bill of lading / airway bill, certificate of origin, insurance (for CIF), inspection or quality certificate, shipping bill copy — exactly as the LC describes.
- 5Step 5 — Documents are presented to the negotiating bank, which examines them under UCP 600 and forwards them to the issuing bank; clean documents mean payment (at sight) or acceptance of a usance draft for payment on the due date.
- 6Step 6 — The issuing bank releases the documents to the importer against payment or acceptance; the importer clears the goods. If the importer refuses to pay, the issuing bank still pays the exporter's bank and recovers from the importer's collateral.
Kinds of LC you will meet
| Type | Meaning |
|---|---|
| Sight LC | Payment on presentation of compliant documents |
| Usance (deferred) LC | Payment 30, 60, 90 or 180 days after shipment or sight — the exporter can discount the accepted draft with the bank |
| Irrevocable LC | Cannot be amended or cancelled without all parties' consent — the standard under UCP 600 |
| Confirmed LC | A second bank (usually the exporter's) adds its own undertaking — used when the issuing bank or country carries risk |
| Transferable LC | The beneficiary can transfer part of the LC to a supplier — for merchant exporters |
| Back-to-back LC | A second LC issued on the strength of the first, to pay the exporter's own supplier |
| Revolving LC | Reinstates automatically for repeat shipments under a running contract |
| Standby LC | A guarantee that pays only on default, not on performance |
Costs, discrepancies and alternatives
- •Charges: issuance and margin on the importer's side; advising, confirmation, negotiation and courier charges on the exporter's side — typically a fraction of a percent each, agreed in the contract.
- •Discrepancies are the commonest cause of delayed payment — a spelling difference, a late shipment date, a missing signature. Have the bank or a CA check documents before presentation.
- •Realise proceeds within the FEMA period and obtain the e-BRC; an LC does not exempt you from EDPMS closure.
- •Alternatives: ECGC export credit insurance covers buyer default on open-account terms; a bank guarantee or standby LC covers performance; for repeat trusted buyers, DP/DA terms with ECGC cover may be cheaper.
Letter of Credit: questions we are asked
The issuing bank, against compliant documents. If the importer refuses, the bank still pays and recovers from the importer.
Non-payment if documents are discrepant or shipment breaches the LC terms — perform exactly as the LC says and check documents before presentation.
Sight pays on presentation; usance gives the buyer credit and lets you discount the accepted bill with your bank.
When the issuing bank or the buyer's country carries risk — a confirming bank in India adds its own undertaking.
The ICC's UCP 600, which every bank applies to document examination and payment.
Yes — contract and LC drafting review, document preparation and checking, bank coordination, and ECGC cover where needed.