A Letter of Credit (L/C) is one of the most widely used payment instruments in international trade, and its core logic isUse bank credit to bridge the distrust between buyer and seller. In simple terms, the buyer arranges for a bank to issue a written undertaking: as long as the seller presents documents that comply with the terms of the letter of credit, the bank assumes the payment obligation. According to the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits (UCP600), roughly 40% of global cross-border trade is settled via letters of credit; in developing countries, this figure reaches as high as 60%.

Letter of Credit Operating Procedure

1. Signing the Contract and Opening the Letter of Credit: The sales contract stipulates payment by L/C → the buyer (applicant) applies to the local bank for issuance → the issuing bank reviews and then issues the letter of credit.
2. Transmission and Notification: The issuing bank sends the letter of credit via the SWIFT system to the advising bank located in the beneficiary’s (seller’s) country → the advising bank verifies its authenticity and then forwards it to the seller.
3. Stocking and Document Submission: The seller ships the goods as required by the letter of credit → collects documents such as the bill of lading, invoice, and packing list → submits the documents to the negotiating bank.
4. Document Review and Payment: After the negotiating bank confirms that the documents conform to the credit, it advances the payment → forwards the documents to the issuing bank → the issuing bank reimburses the negotiating bank → the buyer pays to redeem the documents and take delivery of the goods.

Three Major Advantages of Letters of Credit

1. Risk hedging mechanism

• For the seller: payment is received simply by presenting compliant documents, eliminating the risk of the buyer’s bankruptcy or refusal to pay;
• For the buyer: Ensure payment is made only after confirming the goods meet the contractual requirements, preventing seller fraud.

2. Financing Leverage

• Packing loan: The seller may obtain an advance of up to 80% of the payment against the letter of credit from the bank (annual interest rate approximately 4%–6%);
• Negotiation discounting: Obtain immediate advance from the negotiating bank upon presentation of documents, accelerating capital turnover.

3. Global Universality

• UCP600 is recognized by 178 countries worldwide, and its standardized clauses reduce the risk of legal conflicts.

Four Major Risks of Letters of Credit

1. High cost

Issuance fee (0.1%-0.5% of cargo value) + advising fee ($50-$200) + negotiation fee (0.125% of cargo value); total cost is roughly 1%-3% of cargo value.

2. The process is complex and time-consuming

Document review takes an average of 5–7 business days, the discrepancy rate is as high as 35%, and the cost of each amendment is approximately $200.

3. Soft-clause trap

For example: “The goods must be inspected by personnel designated by the buyer” (depriving the seller of the initiative to present documents).

4. Bank Credit Risk

The default rate on letters of credit issued by emerging-market banks rose to 1.2% in 2023, as foreign-exchange controls in countries such as Sri Lanka and Argentina triggered a surge in bank refusals to pay.

Risk Response

1. Document Risk

Issue: Details such as a bill of lading date later than the L/C expiry or an incorrect decimal point in the invoice amount can all lead to dishonor.

Countermeasures：

• Use professional document-generation software (such as AEB or EDI systems) to automatically validate data;
• Confirm key information (such as shipping date and cargo description) with the forwarder and factory in advance.

2. Clause Risk

Issue: Vague clauses (such as “the applicable law shall be determined by the issuing bank”) may give rise to disputes.

Countermeasures：

• Request the deletion of "non-documentary conditions" (such as "the goods must be to the buyer's satisfaction");
• Always insist on issuing the letter of credit in the SWIFT MT700 standard format and avoid handwritten additional clauses.

3. Bank Risk

Issue: Some banks have insufficient creditworthiness or maliciously nitpick discrepancies.

Countermeasures：

• Priority acceptance of letters of credit issued by internationally recognized mainstream banks;
• Take out Sinosure’s Letter-of-Credit Insurance to cover the risks of bank insolvency or unjustified dishonor.

4. Political Risk

Issue: War and foreign-exchange controls have caused payment delays.

Countermeasures：

• Opt for an irrevocable letter of credit (Irrevocable L/C) with confirmation added (Confirmed L/C);
• A decentralized settlement currency (e.g., using the euro or the renminbi to hedge against U.S. dollar risk).

Alternatives to Letters of Credit and Combined Strategies

1. Hybrid payment

“30% T/T in advance + 70% L/C” reduces the buyer’s capital pressure while safeguarding the seller’s rights and interests.

2. Backup Plan

For high-credit buyers, the transaction can be converted to open account (OA), but it must be paired with export credit insurance (with a maximum indemnity ratio of 90%).

3. Digital Upgrade:

Using blockchain-based letters of credit, the document-checking time is cut from 7 days to 24 hours, and costs are reduced by 30%.

結論

A letter of credit is both the “safety valve” of international trade and the touchstone for testing a company’s risk-control capabilities. Companies are advised to build a “three-line defense”:

1. Frontend Negotiation: Strictly review the terms of the letter of credit and reject any ambiguous wording;
2. mid-range execution: Standardize the document preparation process and introduce third-party document review services;
3. backend fallback: Take out credit insurance and set aside a budget for legal proceedings.

As financial technology advances, letters of credit are evolving from paper documents to digital formats, yet their core logic remains unchanged. Only by rigorously attending to the details of the rules can one navigate global trade with steady progress. Finally, if you need more support from us when conducting import and export trade, please feel free to contact us!