Letter of credit meaning: how it works, types, costs and documents

THURSDAY, 29 OCTOBER 2026

The documentary credit explained for importers: the parties, the five steps, the UCP 600 rules (5 banking days, 21 days after shipment, 10% tolerance), confirmation, payment types, discrepancies and how the cost is built up.

The letter of credit meaning, in short: an irrevocable undertaking by which a bank, acting for the buyer, commits to pay the seller when the seller presents documents that comply with the terms written in the credit. The supplier gets a bank's guarantee instead of the customer's promise alone, and the importer knows payment is released only against the documents that prove shipment.

It is also called a documentary credit, abbreviated as L/C or LC. This guide explains who the parties are, how it works step by step, which international rules govern it, which types exist, which documents are requested, how the cost is built up and when it really makes sense for a company buying from China or Asia and importing to Europe.

Letter of credit meaning and the parties involved

A documentary credit involves at least four parties. The applicant is the importer, who asks its own bank to open the credit. The issuing bank is the importer's bank, which takes on the payment undertaking. The beneficiary is the foreign supplier in whose favour the credit is opened. The advising bank, usually in the supplier's country, notifies the credit to the supplier. When the advising bank, at the request or with the authorisation of the issuing bank, adds its own independent undertaking to pay, it becomes the confirming bank.

The principle behind it all is that the credit is separate from the sales contract: banks examine documents, not goods. If the documents presented match the terms of the credit to the letter, the bank pays even if the goods, once they arrive, turn out to differ from what was ordered. That is why a letter of credit protects the importer only as far as the documents it asked for protect it.

How it works, step by step

The typical path of a purchase paid by letter of credit follows five steps:

• Contract: importer and supplier agree in the contract on payment by documentary credit, the Incoterm, the documents and the dates.
• Issuance: the importer asks its bank to issue the credit; the bank does so only if the importer has a credit facility covering the amount.
• Advice: the issuing bank sends the credit to the advising bank, which notifies it to the supplier.
• Shipment and presentation: the supplier ships the goods and presents the required documents to the bank named in the credit, within the stated deadlines.
• Examination and payment: the banks check the documents; if they comply, the supplier is paid and the importer receives the documents needed to collect the goods.

The credit facility step is the one many small companies discover late. For the issuing bank a documentary credit is a risk, because it commits to pay even if the customer then lacks the funds: an adequate facility is needed, and it should be requested before signing the contract with the supplier.

The UCP 600 rules: the numbers to know

Almost all documentary credits are subject to the Uniform Customs and Practice of the International Chamber of Commerce, known as UCP 600. A few figures in these rules decide whether a payment arrives or stalls:

• 1 July 2007: the date UCP 600 came into force; the rules have 39 articles and are still the version in use.
• Irrevocable: under UCP 600 the credit is an irrevocable undertaking; amending or cancelling it requires the agreement of the beneficiary and of the banks involved.
• 5 banking days: the maximum time each bank involved has, from the day of presentation, to decide whether the documents comply.
• 21 calendar days after the date of shipment: the deadline for presenting documents that include an original transport document, and in any case no later than the expiry of the credit, unless the credit says otherwise.
• 10% more or less: the tolerance allowed on amount, quantity or unit price when the credit uses the word about or approximately.

If a bank refuses the documents, it must do so in a single notice listing all the discrepancies. The detail matters: a credit with a short expiry and a supplier who is slow to gather documents is a combination that produces late presentations.

Irrevocable, confirmed or unconfirmed

With an unconfirmed credit the supplier relies only on the issuing bank's undertaking, which for a European importer means a European bank. With a confirmed credit a second bank, usually in the supplier's country, adds its own independent undertaking: the supplier is also covered against the risk that the issuing bank or its country does not pay.

For buyers in China confirmation is usually the supplier's request, not the importer's need. The cost of confirmation, though, ends up in the price or the terms, and it varies: banks price it case by case based on amount, tenor, country risk and the issuing bank. Before accepting a confirmed clause it is worth asking who pays the confirmation fee and writing it into the contract.

At sight, deferred payment, acceptance or negotiation

The credit also states when and how the supplier is paid. In a sight credit payment is made on presentation of complying documents. In a deferred payment credit the bank commits to pay at a future date, for example 60 or 90 days after shipment: the supplier is certain to be paid, the importer has time to receive and sell the goods. In an acceptance credit the bank accepts a draft with a future maturity. In a negotiation credit a nominated bank advances the amount to the supplier against complying documents.

For an importer, the practical difference is financial. A 90-day credit pushes the cash outflow forward, but the supplier may reflect it in the price or ask to discount the credit with its own bank.

Transferable, back to back and standby

Some special forms often appear in purchases from Asia. A transferable credit allows the beneficiary, typically a trading company or an intermediary, to transfer the credit in whole or in part to a second beneficiary, the manufacturer that actually ships. It must be expressly stated as transferable in the text. A back to back credit is the solution when the credit is not transferable: the intermediary uses the credit it received as the basis for opening a second one in favour of its own supplier.

A standby letter of credit is something else. It is not the normal way to pay for a supply: it is a guarantee used only if the debtor fails to pay. With a documentary credit the beneficiary wants to draw on it; with a standby it hopes never to have to.

The required documents and discrepancies

The text of the credit lists the documents the supplier must present. In sea imports from China the most common are the commercial invoice, the bill of lading, the packing list, the certificate of origin, any inspection certificate and, under CIF or CIP, the insurance certificate.

The most frequent discrepancies are trivial: a goods description on the invoice that differs by one word from the credit, a presentation after 21 days, a shipment after the latest date allowed, a bill of lading noting damage, weights, quantities or party names that do not match from one document to another, a missing certificate. When it finds a discrepancy the issuing bank may refuse payment; in practice it may also ask the importer whether it accepts the documents anyway, without being obliged to. The practical advice is to require in the credit only the documents that are really needed and that the supplier can produce: every extra requirement is another chance of a discrepancy.

How much a letter of credit costs

The cost depends on the bank and the credit facility, and is set out in the bank's fee sheet and contract. In Italian banks' fee sheets the structure recurs: an issuance fee calculated as a percentage per quarter or part of a quarter of the credit's validity; a utilisation fee as a percentage of the amount paid, with a minimum; a fixed charge for each amendment; charges for examining and sending documents; and, if requested, a confirmation fee that varies with country risk and the issuing bank. Charges claimed by foreign correspondent banks are usually passed on to the customer.

The result is that on small orders the minimums and fixed charges weigh heavily in proportion; on large orders the percentage linked to the tenor matters most. Every amendment to the credit, for a moved date or a changed port, has a cost and takes time.

Worked example: a 60,000 dollar order from Shenzhen

A hypothetical example, with hypothetical rates. A company in Padua buys lamps from a Shenzhen manufacturer for 60,000 dollars, FOB, with an irrevocable, unconfirmed sight letter of credit. The credit is valid for four months and requires an invoice, a bill of lading to the order of the bank, a packing list and an inspection certificate.

With a hypothetical issuance fee of 0.30% per quarter, four months count as two quarters: 0.60% of 60,000, or 360 dollars. With a hypothetical utilisation fee of 0.20%, another 120 dollars are added, plus about 100 euros of fixed charges. In total about 600 dollars, 1% of the order. If the supplier ships on 10 March, it must present the documents by 31 March; the bank then has at most five banking days to examine them. A wrong date on the bill of lading, discovered at that point, can cost an amendment and weeks of delay.

When it makes sense for importers from China

In most purchases from China payment is made by bank transfer, often with a deposit at order and the balance against a copy of the bill of lading. A letter of credit becomes worthwhile in three cases: a large first order with a new supplier, when neither party wants to carry all the risk upfront; a supplier that requires it as a condition; an amount large enough to justify the costs and handling time. It does not replace quality control: the bank pays against documents, so it is the inspection certificate required in the credit that links payment to the real condition of the goods.

With La Merce the letter of credit is prepared before the order is signed: we agree with the supplier on documents, shipment dates and the 21-day presentation period, and we add the pre-shipment inspection to the required documents, so the bank pays only once the goods have been checked.

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