An exporter once shipped goods to a new overseas buyer without any payment security. The buyer delayed payment for months. She had no real way to enforce it.

This is exactly the risk a Letter of Credit removes. This guide covers what is Letter of Credit, how it works, and which type suits your trade deal.

What is a Letter of Credit (LC)?

A Letter of Credit is a bank’s written promise to pay a seller on a buyer’s behalf, once specific conditions are met. The bank doesn’t check the actual goods. It checks the paperwork.

Most international LCs follow a standard set of rules called UCP 600. Banks compare submitted documents strictly against the LC terms. Even a small mismatch can lead to refused payment.

How Does a Letter of Credit Work?

The buyer approaches their bank and asks for an LC to be issued in the seller’s favour. The bank reviews the buyer’s credit standing and issues the LC, setting out exact terms and required documents.

The seller ships the goods and submits the required paperwork to their bank. Once the documents match the LC terms exactly, payment gets released, without either party needing to trust the other blindly.

Parties Involved in a Letter of Credit

Applicant

This is the buyer. They start the process by requesting the LC and setting its terms.

Beneficiary

This is the seller. They receive payment once they submit compliant documents.

Issuing Bank

This bank issues the LC on the buyer’s behalf, after assessing creditworthiness, and commits to paying once conditions are satisfied.

Confirming/Negotiating Bank

This bank reviews the seller’s submitted documents and processes payment, making sure everything lines up with the LC’s requirements.

Documents Required for an LC Transaction

• Commercial invoice: shows price and payment terms, used to confirm the sale
• Bill of Lading or Air Waybill: proves the goods were actually shipped
• Packing list: details quantities and weights, matched against the invoice
• Certificate of Origin: confirms where the goods were made, relevant for customs
• Insurance certificate: shows coverage during transit, as required by the LC
• Bill of Exchange: a formal payment demand, where the LC calls for one
• Inspection certificate: independent quality or quantity verification, if required
• Any special permits or certificates specific to the goods being traded

Types of Letters of Credit

Sight Credit

Payment happens as soon as the seller presents correct documents. This works well when a business needs quick access to funds after shipping.

Acceptance/Time Credit

Here, the bank accepts the bill on presentation but pays only on a later, agreed date. Sellers get paid after a set period rather than immediately.

Revocable vs Irrevocable LC

A revocable LC can be changed or cancelled by the issuing bank without the seller’s agreement, which makes it fairly unreliable. An irrevocable LC can’t be altered without everyone’s consent, and most exporters prefer this for that exact reason.

Confirmed LC

A second bank, the confirming bank, adds its own guarantee on top of the issuing bank’s promise. This gives sellers extra assurance, especially when dealing with an unfamiliar foreign bank.

Back-to-Back LC

One LC is used as security to open a second LC, typically so a trader can pay their own supplier using the credit backing from the buyer’s original LC.

Transferable LC

The original beneficiary can pass on all or part of the credit to another party, usually their own supplier. Once transferred, that second party can’t transfer it further.

Revolving LC

This one renews automatically after each use, which suits businesses making repeated shipments under a single ongoing arrangement.

Why is a Letter of Credit Important in Trade?

• Gives sellers payment security without needing an advance from the buyer
• Standardises how cross-border payments work, regardless of country
• Can support financing, since banks may treat a confirmed LC as reliable collateral
• Builds trust between parties who’ve never worked together before

Benefits of LC for Buyers and Sellers

For buyers, an LC offers payment assurance and stronger negotiating position, though it can tie up credit lines or require collateral. For sellers, especially with a confirmed LC, it means predictable, secured receivables, provided the documentation is prepared correctly. Both sides pay bank charges for this security, and paperwork errors can still cause delays, so accuracy matters throughout.

IEC Requirement for Opening an LC

In India, an Import Export Code is generally required when opening an LC for cross-border trade. Banks typically ask for your IEC along with standard business registration documents before underwriting the LC application.

If you’ve already registered your IEC for other export activities, keeping it updated and handy speeds up your LC application process too.

Letter of Credit vs Bank Guarantee: Key Differences

Basis	Letter of Credit	Bank Guarantee
Primary purpose	Ensures payment for a trade transaction	Compensates for non-performance or default
When it activates	Used as the standard payment method	Invoked only if something goes wrong
Role in the deal	Primary payment mechanism	Secondary, backup protection

Precautions Before Using an LC

• Confirm the issuing bank is genuinely reliable, especially for unfamiliar foreign banks
• Route the LC through a trusted Indian bank for local verification
• Clearly agree in advance on who covers bank charges and freight costs
• Double-check every document against the LC terms before submission

Common Mistakes in LC Transactions

• Submitting documents that don’t exactly match the LC’s stated terms
• Choosing a revocable LC when payment certainty actually matters
• Not verifying the issuing bank’s credibility before shipping goods
• Missing the IEC requirement before applying for an LC
• Overlooking who’s responsible for bank charges, leading to disputes later

Why Choose FEMA Expert for Trade Finance & EXIM Compliance

At FEMA Expert, we help exporters and importers work through LC documentation and broader trade compliance, so payment delays don’t come down to a paperwork mismatch.

Since LC transactions often connect to wider foreign investment and remittance matters, our FEMA advisory team, including our FDI consultant in India services, can support that side of your cross-border business too.

Setting up your first LC or facing a documentation issue? Reach out to FEMA Expert for guidance.

Conclusion

A Letter of Credit gives both buyers and sellers real payment security in trade, but the benefit only holds if the documentation is accurate and the right type of LC is chosen for the deal. Getting these details right protects your cash flow and your trading relationships.

If you’re setting up an LC for an upcoming trade transaction, FEMA Expert’s team can help you get the documentation and compliance right.

(FAQs)

1. What is meant by a Letter of Credit? 

It’s a guarantee from the bank. It makes sure a seller gets paid after they provide documents that match the buyer’s agreed terms.

2. What is the difference between LC and bank guarantee? 

An LC is the primary way payment happens in a trade deal, while a bank guarantee only comes into play if one party fails to perform.

3. Which type of LC is safest for sellers? 

A confirmed LC, since it adds a second bank’s guarantee alongside the issuing bank’s commitment.

4. Is IEC mandatory for opening a Letter of Credit? 

Yes, for cross-border trade in India, banks generally require a valid IEC before opening an LC.

5. What is the difference between revocable and irrevocable LC? 

A revocable LC can be changed or cancelled without the seller’s approval. In contrast, an irrevocable LC needs everyone’s agreement to be altered.

6. What documents does a bank check before releasing LC payment? 

Commonly the commercial invoice, bill of lading, packing list, certificate of origin, and insurance certificate, matched exactly against the LC terms.

7. Is there a fixed limit on how much an LC can cover? 

No, banks set limits individually based on the buyer’s creditworthiness, transaction size, and their own risk policies.

8. How can FEMA Expert help with Letter of Credit transactions? 

We help businesses prepare accurate LC documentation and manage related FEMA and foreign investment compliance for smoother cross-border trade.