A letter of credit is the classic safety net of export trade – a bank's payment commitment that removes credit risk from the seller and gives the buyer certainty of delivery. As an entrepreneur, I have seen how letters of credit have enabled export trade to markets where direct payment would be too risky. According to the Bank of Finland, letters of credit account for about 8% of Finnish export trade, but the value share is significantly higher.
What Is a Letter of Credit?
A letter of credit (in English letter of credit, abbreviated L/C) is a written commitment by a bank in which the bank promises to pay the seller an agreed amount when the seller presents documents complying with the letter of credit terms. Letters of credit are governed by the international ICC UCP 600 standard, which harmonizes practices worldwide.
The basic idea of a letter of credit is simple: the bank takes on the buyer's credit risk and guarantees the seller payment. In return, the bank receives a commission and ensures, based on documents, that the goods have actually been delivered.
How Does a Letter of Credit Work in Practice?
The letter of credit process typically involves four parties: the buyer (applicant), the seller (beneficiary), the issuing bank and the advising/confirming bank. The process proceeds as follows:
Letter of credit process steps:
- 1. The buyer and seller agree on the trade and the use of a letter of credit in the trade contract
- 2. The buyer requests their bank to open a letter of credit in favor of the seller
- 3. The issuing bank sends the letter of credit to the advising bank in the seller's country
- 4. The advising bank notifies the seller and verifies the letter of credit's authenticity
- 5. The seller ships the goods and presents the required documents to their bank
- 6. The bank examines the documents and pays the seller (or accepts a bill of exchange)
- 7. The documents are sent to the issuing bank, which debits the buyer
Important: In letter of credit transactions, the bank only examines documents, not goods. Therefore, the documents must exactly match the letter of credit terms – even a small discrepancy can delay payment or result in payment refusal.
Types of Letters of Credit
Irrevocable Letter of Credit
An irrevocable letter of credit is the standard in export trade. It cannot be modified or canceled without the consent of all parties. Under UCP 600, all letters of credit are irrevocable unless stated otherwise.
Confirmed Letter of Credit
In a confirmed letter of credit, the seller's bank (advising bank) adds its own payment commitment alongside the issuing bank's commitment. This protects the seller from the issuing bank's and the buyer's country risk. Confirmation is recommended in high-risk countries.
Standby Letter of Credit
A standby letter of credit functions practically as a bank guarantee. It is activated only if the buyer does not pay as agreed. It is more flexible and cheaper than a traditional letter of credit and is suitable for recurring trade relationships.
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Letter of Credit Costs
The cost of a letter of credit consists of several components and is typically 0.5–3% of the transaction value. The cost is affected by the trade size, validity period, the buyer's country risk and the type of letter of credit.
Letter of credit cost components:
- Opening commission (buyer's bank): 0.1–0.5% per quarter
- Confirmation commission (seller's bank): 0.1–2% one-time fee, depending on country risk
- Negotiation commission: 0.1–0.25% of the invoice value
- Document fees: EUR 50–200 per document set
- Amendment fees: EUR 50–150 per amendment
- SWIFT messages: EUR 30–80 per message
Example: EUR 100,000 export trade to Turkey, 90-day letter of credit Opening commission: 0.25% = EUR 250 Confirmation commission: 0.5% = EUR 500 Negotiation commission: 0.15% = EUR 150 Document fees: EUR 150 Total cost: approximately EUR 1,050 (1.05% of the transaction value) Cost-benefit: EUR 1,050 is a small price for certainty when dealing with a new trading partner.
When Is a Letter of Credit Worthwhile?
A letter of credit is recommended when:
- The trading partner is new and there is no credit history
- The buyer's country's political or economic risk is high
- The transaction value is large (over EUR 50,000)
- Products are custom-made and cannot be sold elsewhere
- The payment term is long (over 90 days)
- The buyer's creditworthiness is difficult to assess
Letter of Credit vs. Other Payment Methods
Practical Tips for Letter of Credit Trade
Tips for export companies:
- Check the letter of credit terms immediately upon receipt – request amendments before shipment
- Prepare documents carefully – even a small error can delay payment
- Use standard trade terms (Incoterms 2020)
- Negotiate letter of credit confirmation if the buyer's country risk is high
- Discount the letter of credit if you need funds before the due date
- Ask your bank's trade finance department for advice – they are the experts
"A letter of credit is like insurance in export trade – you hope you do not need it, but you are grateful when you have it. In new markets, it is almost essential."
Summary
A letter of credit is the safest payment instrument in export trade, protecting both the seller and the buyer. It is especially worthwhile for large trades, with new trading partners and in high-risk countries. The cost is typically 0.5–3% of the transaction value, which is a reasonable price for certainty.
📌 Summary
A letter of credit is a bank's payment commitment that guarantees export trade payment. Types include irrevocable, confirmed and standby. The cost is 0.5–3% of the transaction value. A letter of credit is especially worthwhile with new partners, high-risk countries and large trades.
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