Quick answer
A letter of credit is an undertaking by a bank, issued at the buyer's request, to pay the seller a set amount when the seller presents documents that comply exactly with the credit's terms. It replaces trust between buyer and seller with the banks' involvement. Most letters of credit are issued under the International Chamber of Commerce's UCP 600 rules. They reduce payment risk but add fees and strict paperwork.
Key points
- The bank pays against documents, not goods — the documents must comply exactly with the credit.
- For exporters, a letter of credit reduces the risk of not being paid; for importers, it helps win a supplier's confidence.
- Discrepancies in documents are common and can delay or jeopardise payment.
- A letter of credit manages risk; the time gap until payment may still need funding.
Why do letters of credit exist?
International trade has a trust problem. The seller doesn’t want to ship goods to a buyer on the other side of the world who might not pay. The buyer doesn’t want to pay a seller they’ve never met for goods they haven’t seen. A letter of credit solves it by putting banks in the middle. The seller is paid by a bank, as long as they produce the right documents; the buyer knows the bank won’t pay unless those documents show the goods were shipped as agreed.
Most letters of credit are issued subject to the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits, known as UCP 600. The ICC also publishes eUCP rules for electronic presentation.
How does a letter of credit work, step by step?
- Contract. Buyer and seller agree to use a letter of credit, with the goods, price, shipment dates and documents set out.
- Issue. The buyer asks its bank (the issuing bank) to issue the credit in favour of the seller.
- Advise. A bank in the seller’s country (the advising bank) passes it to the seller and checks it’s authentic.
- Check the credit. The seller reads every term the day it arrives and asks for amendments if anything can’t be met.
- Ship. The seller ships and collects the required documents.
- Present. The seller presents the documents within the credit’s time limits.
- Examine and pay. The bank checks the documents. If they comply, payment is made — at sight, or on the due date for a usance credit.
- Release. The buyer pays or reimburses their bank and receives the documents to collect the goods.
Which documents are usually required?
| Document | What it shows |
|---|---|
| Commercial invoice | Goods, quantities, price and terms matching the credit |
| Packing list | How the goods are packed — cartons, weights, marks |
| Bill of lading or air waybill | That the goods were shipped, when and to whom |
| Insurance certificate | Cover as required (often under CIF or CIP terms) |
| Certificate of origin | Where the goods were made — may matter for duty in the destination |
| Inspection certificate | Independent check of quantity or quality, if required |
The word that matters is exactly. A spelling difference, a wrong port or a shipment one day after the latest date can create a discrepancy.
What does a letter of credit mean for an Australian exporter?
For exporters, the main benefit is payment security: once compliant documents are presented, a bank — not just the buyer — has undertaken to pay. That can make a large first order from an unknown buyer possible. A confirmed credit adds a second bank’s undertaking, useful where the issuing bank or country is a concern.
It doesn’t necessarily mean fast payment. Under a usance credit you may wait 60, 90 or more days, and you still have to fund production first. See pre-shipment finance and export working capital. If you’d like to talk about funding either side, a short enquiry gets a real person on it, with no credit check to ask.
And for an Australian importer?
For importers, a letter of credit can win a new supplier’s confidence and may earn better terms than paying a large deposit up front. The trade-off is that your bank will usually need security or an approved facility to issue it, and there are fees for issuing, amending and handling. Because the bank pays against documents, not goods, it’s worth requiring an inspection certificate for important orders. See paying the supplier balance before shipment for alternatives.
What are the common traps?
- Impossible terms. A shipment date the factory can’t meet, or a document you can’t obtain. Fix them by amendment before you ship.
- Inconsistent details. Descriptions that differ between invoice, packing list and bill of lading.
- Late presentation. Credits set a period for presenting documents after shipment; miss it and you risk non-payment.
- Incoterm mismatches. An insurance certificate required under a term where the seller doesn’t arrange insurance, or vice versa. See Incoterms for importers.
- Assuming payment is instant. Checking documents takes time, and usance credits add a set delay.
Letter of credit or documentary collection?
A documentary collection (the ICC publishes URC 522 rules for these) also routes documents through banks, but the banks don’t undertake to pay. They release the documents to the buyer against payment or acceptance of a bill. It’s cheaper and simpler than a letter of credit, but the seller relies on the buyer’s willingness to pay. It often suits established relationships where some bank involvement is still wanted.
Illustrative example
Illustrative only. An Australian wine producer receives a 90-day usance letter of credit for a first order from an overseas importer. The credit requires shipment by a date that’s tight for bottling. The producer asks for an amendment extending it by two weeks before accepting the order, checks every document against the credit before presenting, and uses a working-capital facility to cover production and the 90-day wait. Payment arrives on the due date without discrepancies.
Pair the paperwork with the funding
A letter of credit can make a trade safer, but it won’t pay your suppliers or staff in the meantime. If you’d like to fund the time around it, start your Trade Loan enquiry. There’s no credit check to ask, and we don’t hand your enquiry to a crowd of lenders — a real person reviews it and calls. Please be accurate about the order value, payment terms and dates so we can match you properly first time.
Frequently asked questions
What is a letter of credit in simple terms?
It's a bank's undertaking to pay the seller when the seller presents documents — such as the commercial invoice, packing list and bill of lading — that match the terms of the credit exactly. The buyer's bank issues it at the buyer's request.
What's the difference between a sight and a usance letter of credit?
A sight credit pays when compliant documents are presented. A usance (or deferred payment) credit pays a set number of days later — for example, 90 days after the bill of lading date — which gives the buyer time but means the seller waits.
What is a confirmed letter of credit?
A letter of credit that a second bank — often in the seller's country — has added its own undertaking to. It protects the seller against the risk of the issuing bank or its country not paying.
Why do payments under letters of credit get delayed?
Usually because of discrepancies — documents that don't exactly match the credit, such as a wrong description, a late shipment date or a missing signature. Discrepancies must be resolved or waived before payment.
Do small businesses use letters of credit?
Yes, particularly for large or first orders with new trading partners. For routine orders with trusted partners, the cost and paperwork can outweigh the benefit.