Letter of credit
A letter of credit is an irrevocable arrangement that constitutes a definite undertaking by an issuing bank to honour a complying presentation of documents. Under the ICC Uniform Customs and Practice for Documentary Credits (UCP 600), a credit is irrevocable even if that is not stated, and the bank's obligation turns on documents that satisfy the credit terms, UCP provisions and international standard banking practice.
Letter of credit use on bank export finance desks
On EF desks a letter of credit is the classic payment and documentary-risk instrument for cross-border goods and services. The applicant, typically the buyer, asks its bank to issue; the beneficiary, typically the exporter, ships and presents documents. Availability must be stated as sight payment, deferred payment, acceptance or negotiation. A nominated bank may honour or negotiate when so authorised. Confirmation by another bank adds a second independent undertaking and is treated separately as a confirmed letter of credit. Standby forms used for performance or financial support are drafted under a dedicated rule set rather than as commercial credits; see standby letter of credit.
Mechanics under UCP 600
UCP 600 Article 2 defines the core vocabulary. A credit is any arrangement, however named or described, that is irrevocable and constitutes a definite undertaking of the issuing bank to honour a complying presentation. Honour means paying at sight, incurring a deferred payment undertaking and paying at maturity, or accepting a draft and paying at maturity. Negotiation is the purchase by the nominated bank of drafts or documents under a complying presentation. Confirmation is a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation.
Article 4 separates the credit from the underlying sale contract: banks are not bound by that contract even if it is mentioned in the credit. Article 5 states that banks deal with documents and not with goods, services or performance. Article 14 gives examining banks a maximum of five banking days following the day of presentation to decide whether the presentation complies. A credit must state an expiry date for presentation and where it is available.
UCP 600 applies when the text of the credit expressly indicates that it is subject to those rules. Commercial LCs remain the primary payment tool; a documentary collection is a lighter bank-handled alternative without an issuing-bank payment undertaking.
Letter of credit versus related instruments
A commercial letter of credit pays against trade documents that evidence shipment or performance as drafted. A standby pays against a demand and stated documents when the applicant fails to perform or pay. A demand guarantee is a parallel independent undertaking family used heavily for bid, performance and advance-payment security. Where a time draft under an acceptance credit is accepted by a bank, the resulting instrument may be discounted as a banker's acceptance.