【Trade Mechanics】What a Letter of Credit Actually Does
Quote from chief_editor on June 24, 2026, 5:30 pmLetter of credit in commodity trade: how it works, who issues it, and why it protects both buyer and seller in international transactions.
A Letter of Credit (LC) is a payment instrument issued by a bank on behalf of a buyer, guaranteeing that the seller will receive payment once specific documentary conditions are met. In commodity trade, the LC is one of the most common payment mechanisms precisely because it removes the need for either party to trust the other — the bank's credit substitutes for the counterparty's credit.
The LC creates a conditional payment promise. The seller ships the commodity, assembles a defined set of documents — typically a bill of lading, commercial invoice, packing list, certificate of origin, and inspection certificate — and presents them to a bank. If the documents comply with the LC terms, the bank pays. The buyer's personal willingness to pay on that day is no longer the deciding factor.
How an LC Transaction Works Step by Step
- Buyer and seller agree on a sale contract that specifies LC as the payment method.
- The buyer instructs their bank (the issuing bank) to open an LC in the seller's favor, listing all required documents and the LC expiry date.
- The LC is transmitted to a bank in the seller's country (the advising bank), which informs the seller the LC has been opened.
- The seller ships the commodity and collects the required documents.
- The seller presents the documents to the advising bank (or a nominated bank).
- The bank examines the documents. If they comply with the LC terms on their face — under the rules of UCP 600 — the bank pays the seller.
- The bank sends the documents to the issuing bank, which releases them to the buyer. The buyer uses the bill of lading to take delivery of the cargo.
The examination standard under UCP 600 (Uniform Customs and Practice for Documentary Credits, published by the International Chamber of Commerce) is documentary compliance — the bank checks that the documents are consistent with each other and with the LC terms. The bank does not inspect the physical commodity.
Key LC Terms Every New Trader Should Know
Irrevocable: once opened, the LC cannot be canceled or amended without the seller's consent. Nearly all commercial LCs are irrevocable.
Confirmed: a confirmed LC has a second bank — the confirming bank, usually in the seller's country — adding its own independent payment undertaking. If the issuing bank fails to pay, the confirming bank pays. Sellers dealing with buyers in countries with elevated banking risk often require confirmed LCs.
Sight vs. usance: a sight LC means payment is made immediately upon presentation of complying documents. A usance LC (also called a term LC) means payment is deferred — for example, 60 days or 90 days after the bill of lading date. Usance LCs provide the buyer with a credit period before they must fund the payment.
Discrepancy: when the presented documents do not comply perfectly with the LC terms — a date is wrong, a document is missing, the description of goods does not match — the bank issues a notice of discrepancy. The seller must either correct the documents, ask the buyer to waive the discrepancy, or accept rejection of the presentation.
In a typical commodity trade transaction, assume the seller presents a set of documents and one document shows a slightly different quantity than the bill of lading. That difference — even a small one — is a discrepancy under UCP 600 rules. The bank cannot pay until the discrepancy is resolved.
Why Traders Use LCs
For the seller, the LC converts the buyer's payment promise into a bank's payment promise. The seller no longer depends on the buyer's financial condition on payment day — they depend on the issuing bank's condition, which is typically more stable than an individual company's.
For the buyer, the LC protects against paying for goods that were never shipped or that do not match the agreed specification on paper. The buyer only authorizes the bank to release payment after reviewing documents that confirm shipment took place.
The LC's limitation is that it only verifies documents, not physical reality. A complete set of compliant documents can exist even if the cargo is below specification or, in fraud cases, does not exist at all. This is why physical inspection, cargo insurance, and supplier due diligence remain necessary alongside the LC.
The LC is a documentary payment mechanism that transfers credit risk from the trading counterparty to the banking system, while creating a defined set of documentary conditions that must be satisfied before payment is made.
Letter of credit in commodity trade: how it works, who issues it, and why it protects both buyer and seller in international transactions.
A Letter of Credit (LC) is a payment instrument issued by a bank on behalf of a buyer, guaranteeing that the seller will receive payment once specific documentary conditions are met. In commodity trade, the LC is one of the most common payment mechanisms precisely because it removes the need for either party to trust the other — the bank's credit substitutes for the counterparty's credit.
The LC creates a conditional payment promise. The seller ships the commodity, assembles a defined set of documents — typically a bill of lading, commercial invoice, packing list, certificate of origin, and inspection certificate — and presents them to a bank. If the documents comply with the LC terms, the bank pays. The buyer's personal willingness to pay on that day is no longer the deciding factor.
How an LC Transaction Works Step by Step
- Buyer and seller agree on a sale contract that specifies LC as the payment method.
- The buyer instructs their bank (the issuing bank) to open an LC in the seller's favor, listing all required documents and the LC expiry date.
- The LC is transmitted to a bank in the seller's country (the advising bank), which informs the seller the LC has been opened.
- The seller ships the commodity and collects the required documents.
- The seller presents the documents to the advising bank (or a nominated bank).
- The bank examines the documents. If they comply with the LC terms on their face — under the rules of UCP 600 — the bank pays the seller.
- The bank sends the documents to the issuing bank, which releases them to the buyer. The buyer uses the bill of lading to take delivery of the cargo.
The examination standard under UCP 600 (Uniform Customs and Practice for Documentary Credits, published by the International Chamber of Commerce) is documentary compliance — the bank checks that the documents are consistent with each other and with the LC terms. The bank does not inspect the physical commodity.
Key LC Terms Every New Trader Should Know
Irrevocable: once opened, the LC cannot be canceled or amended without the seller's consent. Nearly all commercial LCs are irrevocable.
Confirmed: a confirmed LC has a second bank — the confirming bank, usually in the seller's country — adding its own independent payment undertaking. If the issuing bank fails to pay, the confirming bank pays. Sellers dealing with buyers in countries with elevated banking risk often require confirmed LCs.
Sight vs. usance: a sight LC means payment is made immediately upon presentation of complying documents. A usance LC (also called a term LC) means payment is deferred — for example, 60 days or 90 days after the bill of lading date. Usance LCs provide the buyer with a credit period before they must fund the payment.
Discrepancy: when the presented documents do not comply perfectly with the LC terms — a date is wrong, a document is missing, the description of goods does not match — the bank issues a notice of discrepancy. The seller must either correct the documents, ask the buyer to waive the discrepancy, or accept rejection of the presentation.
In a typical commodity trade transaction, assume the seller presents a set of documents and one document shows a slightly different quantity than the bill of lading. That difference — even a small one — is a discrepancy under UCP 600 rules. The bank cannot pay until the discrepancy is resolved.
Why Traders Use LCs
For the seller, the LC converts the buyer's payment promise into a bank's payment promise. The seller no longer depends on the buyer's financial condition on payment day — they depend on the issuing bank's condition, which is typically more stable than an individual company's.
For the buyer, the LC protects against paying for goods that were never shipped or that do not match the agreed specification on paper. The buyer only authorizes the bank to release payment after reviewing documents that confirm shipment took place.
The LC's limitation is that it only verifies documents, not physical reality. A complete set of compliant documents can exist even if the cargo is below specification or, in fraud cases, does not exist at all. This is why physical inspection, cargo insurance, and supplier due diligence remain necessary alongside the LC.
The LC is a documentary payment mechanism that transfers credit risk from the trading counterparty to the banking system, while creating a defined set of documentary conditions that must be satisfied before payment is made.