【Trade Finance】How a Letter of Credit Works in Commodity Trading
Quote from chief_editor on May 22, 2026, 3:30 pmHow letter of credit works in commodity trading, step by step. Understand the LC payment process and each bank's role before your first trade.
A Letter of Credit (LC) is a payment instrument issued by a bank that guarantees a seller will receive payment, provided the seller presents a defined set of documents within a specified time. In commodity trading, the LC is one of the primary tools that allows a buyer and seller who do not know each other — often located in different countries — to complete a transaction without either party bearing the full counterparty risk alone.
The reason an LC works is that it substitutes the creditworthiness of the buyer with the creditworthiness of a bank. A seller who might not trust a new trading counterparty in another jurisdiction will often accept payment backed by a reputable international bank.
How the LC Payment Process Works
The LC process follows a specific sequence of steps. First, buyer and seller agree on trade terms, including the requirement that payment will be made via LC. The buyer then instructs their bank — called the Issuing Bank — to open an LC in favor of the seller. The Issuing Bank issues the LC and transmits it, usually via the SWIFT network, to a bank in the seller's country, called the Advising Bank or Confirming Bank.
The difference between an advising bank and a confirming bank is that the confirming bank adds its own payment guarantee on top of the issuing bank's obligation. A seller in a market with restricted banking access may require confirmation from a first-class international bank, ensuring payment even if the issuing bank defaults.
Once the seller receives the LC, the seller ships the goods and assembles the required documents — typically a Bill of Lading (BL), commercial invoice, packing list, certificate of origin, and quality or weight certificates. The seller presents these documents to the Confirming Bank before the LC expiry date. The bank checks the documents against the LC terms. If the documents comply, the bank pays the seller. Then the bank sends the documents to the Issuing Bank, which reimburses the Confirming Bank and releases the documents to the buyer. The buyer uses the original Bill of Lading to take possession of the cargo.
For example, assume a rice trader in Singapore sells 5,000 metric tons to a buyer in West Africa. The West African buyer opens a Sight LC — meaning payment is due immediately upon document presentation — for assume $2.5 million through a local bank. The Singapore trader ships the cargo, presents the documents, and receives payment within a few days of the bank completing its document check. Without the LC, the Singapore trader would have needed to ship the cargo and then trust the buyer to pay afterward.
Sight LC vs Usance LC
A Sight LC requires payment upon compliant document presentation. A Usance LC (also called a Term LC or Deferred Payment LC) allows a payment delay — for example, 60 or 90 days after the Bill of Lading date. Usance terms give the buyer time to sell or process the commodity before the payment falls due, effectively providing short-term trade financing. Sellers who offer usance terms typically price this financing cost into the commodity price.
Discount clauses are sometimes added to usance LCs, allowing the seller to request that the Confirming Bank pay immediately at a discount, while the buyer still pays at maturity. This is one mechanism by which commodity traders access working capital before the payment due date.
The LC is not without limitations. Banks check documents, not physical goods. A compliant document presentation will trigger payment even if the actual cargo does not match expectations — fraud risk exists at the documentary layer, not the banking layer. Due diligence on counterparties and inspection certificates are separate protections that sit outside the LC mechanism.
The Letter of Credit functions as a structured payment guarantee: it shifts the buyer's credit risk to a bank, gives the seller a predictable payment trigger based on documents, and provides both parties a framework for resolving disputes through documentary compliance rather than goodwill.
How letter of credit works in commodity trading, step by step. Understand the LC payment process and each bank's role before your first trade.
A Letter of Credit (LC) is a payment instrument issued by a bank that guarantees a seller will receive payment, provided the seller presents a defined set of documents within a specified time. In commodity trading, the LC is one of the primary tools that allows a buyer and seller who do not know each other — often located in different countries — to complete a transaction without either party bearing the full counterparty risk alone.
The reason an LC works is that it substitutes the creditworthiness of the buyer with the creditworthiness of a bank. A seller who might not trust a new trading counterparty in another jurisdiction will often accept payment backed by a reputable international bank.
How the LC Payment Process Works
The LC process follows a specific sequence of steps. First, buyer and seller agree on trade terms, including the requirement that payment will be made via LC. The buyer then instructs their bank — called the Issuing Bank — to open an LC in favor of the seller. The Issuing Bank issues the LC and transmits it, usually via the SWIFT network, to a bank in the seller's country, called the Advising Bank or Confirming Bank.
The difference between an advising bank and a confirming bank is that the confirming bank adds its own payment guarantee on top of the issuing bank's obligation. A seller in a market with restricted banking access may require confirmation from a first-class international bank, ensuring payment even if the issuing bank defaults.
Once the seller receives the LC, the seller ships the goods and assembles the required documents — typically a Bill of Lading (BL), commercial invoice, packing list, certificate of origin, and quality or weight certificates. The seller presents these documents to the Confirming Bank before the LC expiry date. The bank checks the documents against the LC terms. If the documents comply, the bank pays the seller. Then the bank sends the documents to the Issuing Bank, which reimburses the Confirming Bank and releases the documents to the buyer. The buyer uses the original Bill of Lading to take possession of the cargo.
For example, assume a rice trader in Singapore sells 5,000 metric tons to a buyer in West Africa. The West African buyer opens a Sight LC — meaning payment is due immediately upon document presentation — for assume $2.5 million through a local bank. The Singapore trader ships the cargo, presents the documents, and receives payment within a few days of the bank completing its document check. Without the LC, the Singapore trader would have needed to ship the cargo and then trust the buyer to pay afterward.
Sight LC vs Usance LC
A Sight LC requires payment upon compliant document presentation. A Usance LC (also called a Term LC or Deferred Payment LC) allows a payment delay — for example, 60 or 90 days after the Bill of Lading date. Usance terms give the buyer time to sell or process the commodity before the payment falls due, effectively providing short-term trade financing. Sellers who offer usance terms typically price this financing cost into the commodity price.
Discount clauses are sometimes added to usance LCs, allowing the seller to request that the Confirming Bank pay immediately at a discount, while the buyer still pays at maturity. This is one mechanism by which commodity traders access working capital before the payment due date.
The LC is not without limitations. Banks check documents, not physical goods. A compliant document presentation will trigger payment even if the actual cargo does not match expectations — fraud risk exists at the documentary layer, not the banking layer. Due diligence on counterparties and inspection certificates are separate protections that sit outside the LC mechanism.
The Letter of Credit functions as a structured payment guarantee: it shifts the buyer's credit risk to a bank, gives the seller a predictable payment trigger based on documents, and provides both parties a framework for resolving disputes through documentary compliance rather than goodwill.