Letters of credit: how they protect importers and exporters

So, a letter of credit: what is it? Santander describes it as a written agreement from a bank, made at the request of the buyer, to pay the seller an amount of money within a specified time, provided the seller presents certain documents. Ulster Bank calls it an irrevocable undertaking by a bank on behalf of the buyer. You will also see it called a documentary credit, an LC, or simply a credit letter.

The key idea is that the bank pays against paperwork, not against the buyer's goodwill. If the seller presents the documents the credit asks for, on time and in order, the bank pays. The bank does not inspect the goods. It checks that the invoice, transport document and other papers match the credit's terms.

A letter of credit is one of several tools under the heading of trade finance. That guide covers the wider family, including import loans and supplier finance. This one stays with the letter of credit itself.

This sequence is based on the steps Santander sets out for an export letter of credit, with the names banks give each party; step 4 is a practical check rather than one of Santander's steps.

1. Agree the contract. Seller and buyer agree that payment will be by letter of credit.
2. The buyer applies. The buyer asks its bank (the issuing bank) to open a credit in the seller's favour, listing the exact documents it wants before payment and any other conditions.
3. The credit is advised. The issuing bank sends the credit to the seller through a bank in the seller's country, the advising bank, where possible digitally.
4. The seller checks the terms. Before shipping, compare the credit with the sales contract and ask for an amendment if anything cannot be met.
5. The seller ships and presents. Once the goods or services are delivered as required, the seller presents the specified documents to the bank.
6. The bank examines the documents. If they comply, the bank sends them to the buyer's bank and arranges payment on the credit's terms.
7. Discrepancies go back to the buyer. If documents do not comply and cannot be corrected, they may be referred to the buyer to accept or decline, and payment can follow only once accepted.

Payment can be at sight or at a set future date, such as 60 days from the bill of lading date in Santander's example. Where payment is deferred, the seller can ask its bank to discount the credit and receive payment straight away, less the bank's fees.

For an importer, Ulster Bank describes an import letter of credit as a commitment by the bank to pay your supplier on your behalf, drawn on a credit facility agreed in advance. In practice the bank is lending its name, so it treats the credit as part of your borrowing and may ask for security. A business that buys from abroad often should think of its LC limit alongside its overdraft or revolving credit facility.

Santander lists the usual reasons to use one: trading with a new country, with a higher-risk supplier or country, or starting a new trading relationship.

An ordinary credit is only as good as the bank that issued it. If that bank cannot pay, or the buyer's country stops money leaving, the exporter can be left waiting despite presenting perfect documents.

Confirmation adds a second bank's promise. Santander says an exporter can reduce the risk of non-payment by the buyer's bank, and the related country risk, by asking it to confirm payment. Ulster Bank says it may consider confirming credits for exports to developing countries, guaranteeing payment if the buyer's bank cannot pay, provided the terms are met and the documents are in order.

There is no standard price. Each bank publishes its own tariff and quotes on the deal. Santander says it charges a risk fee, a discount fee, administration charges, costs and expenses on an export credit, with the discount fee set by its assessment of the risk of non-payment, and gives customers its Trade Service Pricing Tariff. Ulster Bank says product fees may apply and security may be required.

• Issuing. The buyer's bank charges for opening the credit.
• Advising. The seller's bank charges for authenticating and passing it on.
• Confirming. A confirming bank charges for adding its own promise to pay.
• Amendments. Changing the credit after issue usually carries a charge.
• Discrepancies. Documents that fail the check can attract a fee as well as a delay.
• Discounting. Getting paid early on a deferred credit is priced like short-term borrowing.

Who pays which fee is agreed in the sales contract. A common split is for each party to pay its own bank's charges, but nothing requires it, so put it in writing.

Most payment delays under a letter of credit come from paperwork that does not match, not from fraud. Santander's factsheet warns that if presented documents do not comply with all the credit's terms, they can be rejected, and advises negotiating terms with the buyer that you can actually meet.

Typical mismatches include:

• Shipping or presenting documents after the deadline in the credit.
• A goods description on the invoice that differs from the wording in the credit.
• Figures or quantities that do not agree across documents.
• A transport document showing a different port or route from the one specified.
• Insurance cover below the amount the credit requires.
• Missing signatures, stamps or certificates the credit lists.
• Presenting after the credit has expired.

Santander notes that letters of credit are usually issued subject to standards published by the International Chamber of Commerce. The current rules are the Uniform Customs and Practice for Documentary Credits (UCP 600), and the ICC's eUCP supplement lets letters of credit be handled electronically.

A letter of credit earns its cost on a large order, a new buyer or a market where banks and currency are less reliable. It is often more than a trade needs when:

• You have traded with the buyer for years and they pay on time.
• The order is small, so fixed bank fees take a large share of the margin.
• Both sides are in stable markets with reliable banking.
• A simpler tool gives enough protection, such as agreed payment terms backed by credit insurance.

UK Export Finance, the government's export credit agency, says its export insurance can cover up to 95% of potential losses under an export contract, such as a buyer becoming insolvent. It is for exporters who cannot get cover from the private sector, and it excludes losses from unresolved disputes with the buyer. For cash tied up in sales on credit terms at home or abroad, invoice finance is the other common route, and our guide to payment terms covers how to set them.

Capzy is a credit broker paid by the lender. We do not issue letters of credit, which come from banks with trade services teams. Where a trade needs funding around it, such as stock bought ahead of a large order, we can introduce you to lenders whose criteria fit. Our types of finance guides cover the options, and you can check your eligibility with a soft search that does not affect your credit score. Any offer is subject to status and lender criteria, and Capzy does not give legal or financial advice.