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Letter of credit explained for first-time exporters

A letter of credit is a promise from the buyer's bank to pay you once you ship the goods and show the right papers. For a first-time exporter, that promise can make a sale to a stranger much safer. It also adds fees, paperwork and rules you must follow to the letter.

This guide walks through how it works, who is involved, what can go wrong and when it is worth the trouble.

What a letter of credit does

You and your buyer agree on a sale. The buyer then asks a bank to open a letter of credit in your favor. The bank agrees to pay you if you meet every condition written in it. Those conditions are about documents, not about whether the buyer is happy with the goods.

That is why exporters like it. The U.S. government describes it as one of the most secure payment instruments available. The buyer is covered too. No payment is due until the goods have shipped as promised.

Sources: U.S. International Trade Administration, Methods of Payment and Letter of Credit pages (trade.gov).

Who is involved

Four parties do most of the work. A freight forwarder may help as a fifth.

  • The exporter ships the goods and hands over the documents. This is you.
  • The exporter's bank checks the letter and the documents.
  • The importer is the buyer. They apply for the letter.
  • The importer's bank writes the letter and pays.

Your own bank reviews the letter before you ship. It is smart to ask it whether the buyer's bank is sound. If you have doubts about that bank, ask your own bank how it would judge the risk.

Sources: U.S. International Trade Administration, Letter of Credit page (trade.gov).

The steps from sale to payment

The flow is the same in most deals.

  1. You and the buyer finish the sales agreement.
  2. The buyer applies to their bank, and the bank drafts the letter from the agreement.
  3. The letter goes to your bank, which approves it and passes it to you.
  4. You read it closely. If a term is wrong or impossible, ask for a change before you ship.
  5. You ship the goods exactly as the letter says and send the required documents to your bank.
  6. Your bank checks the papers. If they are clean, it sends them to the buyer's bank.
  7. The buyer's bank pays your bank and releases the documents so the buyer can claim the goods and clear customs.

Sources: U.S. International Trade Administration, Letter of Credit page (trade.gov).

The rules banks follow

Most letters of credit worldwide are written under a shared rulebook from the International Chamber of Commerce. It is called the Uniform Customs and Practice for Documentary Credits, or UCP 600. It has been in force since 1 July 2007. Banks in many countries use it.

Ask your bank to confirm that your letter is subject to these rules. Then ask it to explain the time limits for shipping and for handing in documents. Miss a date in the letter and you may lose the payment promise.

Sources: International Chamber of Commerce, UCP 600 (effective 1 July 2007), as summarized by Wikipedia, Uniform Customs and Practice for Documentary Credits.

Costs and common mistakes

A letter of credit costs more than most other ways to get paid. Banks charge fees, and the process takes real staff time. Before the buyer applies, ask your bank what each step costs and who pays it.

The biggest risk for you is a mismatch in the papers. The documents are detailed and easy to get wrong. A name spelled two ways, a wrong date or a missing page can count as a discrepancy. A discrepancy must be fixed and sent again. That can delay payment and add fees.

Three habits help:

  • Read the letter the day it arrives and ask for fixes at once.
  • Prepare documents from the letter, line by line, not from memory.
  • Use a trained person or your forwarder to check the set before you send it.

Sources: U.S. International Trade Administration, Letter of Credit page (trade.gov).

When it makes sense

The U.S. government suggests a letter of credit for higher-risk deals. That includes a new or less-known buyer, a case where the buyer's credit is not available or not acceptable, or a request for longer payment terms.

If you know the buyer well and trust them, a simpler method may save money. If you do not, the fees can be cheap insurance. Talk to your bank before you quote a price, so the cost is part of the price.

This is general information only. Before you open or accept a real letter of credit, ask the trade finance team at your bank to confirm the terms of your deal.

Sources: U.S. International Trade Administration, Letter of Credit page (trade.gov).

Sources

  • https://www.trade.gov/letter-credit
  • https://www.trade.gov/methods-payment
  • https://en.wikipedia.org/wiki/Uniform_Customs_and_Practice_for_Documentary_Credits