A letter of credit is a bank-issued payment undertaking used in international trade to reduce risk for both buyer and seller. It promises payment to the exporter when the documents required by the credit are presented correctly, even if the buyer has not yet paid the seller directly.
How it works
The buyer asks its bank to open the credit, and the seller relies on that bank’s commitment as long as the shipment and paperwork match the stated terms. Common documents include the commercial invoice, transport document, packing list, and any certificates required by the contract or customs process.
Because banks pay against documents, not the cargo itself, exact compliance matters. Small discrepancies in names, dates, descriptions, or document wording can delay payment or lead to refusal, depending on the credit terms and the rules governing it, such as the Uniform Customs and Practice for Documentary Credits when incorporated.
Why it matters in shipping
Letters of credit are often used for higher-value or first-time transactions where trust is still developing. They can also help exporters obtain financing before payment is received, while buyers gain some assurance that funds are released only after shipment evidence is shown. Freight forwarders and customs brokers may assist with document preparation, but the banks and the underlying sales contract control the payment mechanism.