Key Takeaways

  • A commercial letter of credit (LC) is a bank-issued document that guarantees payment to a seller once agreed conditions are met.
  • It reduces payment and delivery risk in both domestic and international trade.
  • Buyers gain assurance that goods or services must be delivered before funds are released.
  • Sellers benefit from the substitution of the bank’s credit risk for the buyer’s, which increases reliability of payment.
  • Variations of letters of credit—such as confirmed, revolving, and standby LCs—offer different levels of protection and flexibility.
  • The process typically requires strict documentary compliance, meaning the bank only pays if documents exactly match the contract.
  • Commercial letters of credit are widely used in global trade finance, governed by rules such as the UCP 600.

What is a commercial letter of credit” is a common question for business owners. A commercial letter of credit is a contractual agreement between the banks issuing the credit that authorizes another bank to make payments to the beneficiary on behalf of the customer.

Commercial Letter of Credit

A commercial letter of credit is written on behalf of the customer and allows a different bank than the one issuing credit to make a payment to the beneficiary. In the letter, the issuing bank promises to allow draws made on the credit. The idea behind a letter of credit is similar to escrow. A bank acts as a neutral party and only releases funds after the parties meet certain requirements. In most situations, the beneficiary provides the products or services. Under a letter of credit, the issuing bank takes over from the bank's customer as the payee.

Commercial letters of credit have a longstanding history in international trade. For international matters, the letters are overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The provisions from this group are required for all parties. In the U.S., domestic collections are overseen by the Uniform Commercial Code.

How a Commercial Letter of Credit Works

A commercial letter of credit operates by shifting the risk of non-payment from the buyer to the bank. The issuing bank guarantees that once the seller presents all required documentation—such as a clean bill of lading, commercial invoice, or certificate of insurance—it will release funds. This system ensures that sellers do not ship goods without confidence of payment, and buyers do not pay until proof of shipment is provided.

The transaction typically involves four parties:

  • Applicant – the buyer who requests the letter of credit.
  • Issuing Bank – the buyer’s bank that issues the LC.
  • Beneficiary – the seller who will receive payment.
  • Advising/Confirming Bank – the seller’s bank, which may guarantee payment in addition to the issuing bank.

This structure creates a legally binding obligation that substitutes the creditworthiness of the bank for that of the buyer.

Protection Offered by a Commercial Letter of Credit

A commercial letter of credit offers protection to both parties. The seller is protected because if they don't receive payment from the buyer, the bank that issued the letter of credit is then responsible for paying the seller. That means that the seller knows they will always receive some kind of payment. This is especially helpful for international deals where the buyer and seller are in different countries.

Buyers are protected because if they pay for a product or service that they don't receive, the buyer may be able to get some money back through a standby letter of credit. The payment is similar to a refund and allows the buyer to then find another company to buy the product or service from.

Benefits for International Trade

Commercial letters of credit are especially valuable in cross-border transactions where legal systems and business practices differ. They:

  • Provide assurance to exporters that they will be paid promptly.
  • Reduce country risk, since banks often have stronger international standing than individual buyers.
  • Protect importers by ensuring delivery of goods before funds are released.
  • Streamline trade by offering a standard, regulated process under the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits (UCP 600).

Types of Letters of Credit

There are multiple kinds of letters of credit, each of which is best used in certain situations.

  • A commercial letter of credit offers direct payment from the bank to the beneficiaries receiving payments.
  • A revolving letter of credit lets the customer pull money from the bank in an unlimited number of transactions within a specific time frame.
  • A traveler's letter of credit promises that the bank will accept drafts through accepted foreign banks.
  • A confirmed letter of credit includes a second bank that guarantees the letter of credit. This bank is usually the seller's bank and is known as the confirming bank. In the case that both the issuing bank and the customer can't make payments, the confirming bank will step in to make payments. This type of arrangement is usually requested by the issuing bank in international deals.
  • A standby letter of credit works as a secondary payment tool. A bank issues a standby letter of credit to show that a customer is able to make payments under the terms of the agreement. Both parties expect to never have to draw on this type of letter of credit; the letter is simply there to provide additional support for the customer's financial standing. However, if the customer doesn't meet their obligation, the beneficiary is able to provide evidence and draw on the credit.

Standby letters of credit come with expiration dates and are used to back up monetary obligations, ensure that an advanced payment is refunded, and to assure that a sales contract is completed. These types of letters are typically used to strengthen the creditworthiness of a customer. In most cases, a standby letter of credit is never actually used, especially if the customer makes payments according to the terms set by the seller.

However, if the seller wants to be paid directly and the customer can't pay, the seller can provide evidence and draw on the credit. In domestic situations, the Uniform Commercial Code states that banks have three business days to accept the evidence that payment hasn't been made to then honor the seller's draw on the credit.

Documentary Requirements and Compliance

A defining feature of commercial letters of credit is their reliance on documents, not goods. Banks review shipping and insurance documents rather than physically inspecting merchandise. This principle—called documentary compliance—means that payment is only made if the documents exactly match the LC terms.

While this protects both sides, it also creates challenges:

  • Even minor discrepancies in documents can delay or deny payment.
  • Sellers must carefully prepare paperwork, often using freight forwarders or trade finance specialists.
  • Buyers are assured that payments align precisely with agreed conditions.

Costs and Fees of a Commercial Letter of Credit

Using a commercial letter of credit involves several fees:

  • Issuance fees charged by the issuing bank.
  • Confirmation fees if a confirming bank is added.
  • Document handling fees for processing paperwork.
  • Amendment fees if terms of the LC change.

These costs are generally a small percentage of the transaction value but can vary depending on the complexity of the deal and the parties’ creditworthiness.

Practical Examples of Commercial Letters of Credit

A U.S. importer purchasing machinery from Germany may request a commercial LC. The German exporter ships the equipment and submits the bill of lading and insurance documents to its local bank. Once verified, the bank receives payment from the U.S. issuing bank. This process ensures both parties meet obligations without direct trust or prepayment.

Similarly, in large commodity shipments—such as oil or grain—a commercial LC is often the only acceptable payment method due to the high value and international risks involved.

Frequently Asked Questions

  1. What is the main purpose of a commercial letter of credit?
    It guarantees payment to the seller once the required documents are presented, reducing risk in trade transactions.
  2. Who are the parties involved in a commercial letter of credit?
    The applicant (buyer), issuing bank, beneficiary (seller), and sometimes an advising or confirming bank.
  3. What documents are usually required under a commercial letter of credit?
    Common documents include a bill of lading, commercial invoice, and certificate of insurance.
  4. Are commercial letters of credit expensive?
    They involve fees—such as issuance, confirmation, and document handling fees—but costs are usually a small percentage of the transaction value.
  5. How does a commercial letter of credit differ from a standby letter of credit?
    A commercial LC facilitates payment for goods/services, while a standby LC acts as a backup payment guarantee if the buyer fails to pay.

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