Letter of Credit Explained: Types and How It Works (2026)

What is a letter of credit? A letter of credit (LC), also called a documentary credit, is a promise by a bank to pay a seller on behalf of a buyer, as long as the seller presents the documents the letter of credit asks for. It is used most in international trade, where a buyer and seller in different countries do not know or trust each other well enough to simply ship goods or send money. The point of an LC is to swap the buyer's credit risk for a bank's. Instead of the seller trusting the buyer to pay, the seller trusts the buyer's bank, which is a far stronger promise. The bank does not care whether the goods are good; it pays when the paperwork matches the terms of the credit. This article is general guidance, not legal advice or financial advice. Trade finance rules and local banking practice vary, so take professional advice before relying on an LC for a real transaction. ## How does a letter of credit work? The flow follows a standard set of steps: 1. The sale contract. Buyer and seller agree a deal and agree that payment will be by letter of credit.

2. The buyer applies. The buyer (the applicant) asks its bank (the issuing bank) to open a letter of credit in the seller's favour, setting out the documents required and a deadline.
3. The LC is issued and advised. The issuing bank issues the credit and sends it, usually through a bank in the seller's country (the advising bank), to the seller (the beneficiary).
4. The seller ships and presents documents. The seller ships the goods and presents the required documents, such as the invoice, transport document (for example a bill of lading), insurance certificate and any certificates of origin or inspection.
5. The bank examines the documents. The bank checks the documents against the terms of the credit. If they comply, the bank pays.
6. Payment and reimbursement. The seller is paid, the issuing bank is reimbursed by the buyer, and the buyer receives the documents needed to collect the goods. Two rules sit at the heart of this. First, banks deal in documents, not goods: under the UCP 600 rules, a bank pays against conforming paperwork and is not concerned with whether the goods actually arrived or were as described. Second, the standard is strict compliance: the documents must match the terms of the credit closely. A small mismatch, called a discrepancy, can give the bank grounds to refuse payment until it is fixed or waived. ## What rules govern a letter of credit? Most letters of credit are governed by the UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision), published by the International Chamber of Commerce. Important points about UCP 600: - It is not law. It is a set of rules that applies only because the parties write it into the credit by express reference.

• It does not govern the underlying sale, carriage or insurance contract, only the credit.
• Parties can modify or exclude parts of it for a particular credit.
• It confirms that banks examine documents, not goods (Article 5), and sets out how banks issue, advise, confirm, examine, honour, negotiate, amend and transfer credits. Standby letters of credit may also use UCP 600, or a separate set of rules called ISP98. ## The main types of letter of credit | Type | What it means | |---|---| | Irrevocable | The default and most common. It cannot be changed or cancelled without the agreement of all parties, so the seller has a firm promise. | | Revocable | Can be changed or cancelled by the issuing bank without the seller's agreement. Rare and weak; under UCP 600 a credit is treated as irrevocable unless it says otherwise. | | Confirmed | A second bank, usually in the seller's country, adds its own promise to pay on top of the issuing bank's. Useful when the seller is unsure of the issuing bank or country. | | Unconfirmed | Only the issuing bank's promise stands. | | Sight | Payment is due as soon as compliant documents are presented and checked. | | Usance (or term/deferred) | Payment is due a set number of days after presentation or shipment, giving the buyer time to pay. | | Transferable | The seller (first beneficiary) can transfer all or part of the credit to another party, often a supplier. | | Back-to-back | Two separate credits used by a middleman: an incoming credit backs a second credit issued to the real supplier. | | Standby (SBLC) | A guarantee of last resort. The bank pays only if the buyer fails to perform, so it sits unused unless something goes wrong. | | Revolving | One credit that automatically renews for repeated shipments, so a new LC is not needed each time. | | Red clause | Allows the seller to draw an advance before shipment. | ## What are the advantages and risks? Advantages. The seller gets a bank's promise rather than relying on the buyer, and is paid once the documents are in order. The buyer gets assurance that payment is released only against proof of shipment and the right documents. Both sides get a neutral, internationally understood framework. Risks and costs. Letters of credit are paperwork-heavy, and discrepancies are common, which can delay payment. They cost money: issuing, advising and confirming fees add up. The buyer's working capital is tied up or its credit line is used. And because banks look only at documents, an LC does not protect a buyer against goods that are poor quality but correctly documented. That risk is managed through the sale contract and inspection, not the LC. ## Does a letter of credit work across jurisdictions? Largely yes, which is the point. Because most LCs incorporate UCP 600, the core rules are the same in most trading countries. What varies by jurisdiction is the surrounding law: local banking regulation, foreign-exchange controls, stamp duty and the courts that would hear a dispute. In India, for example, LCs are issued within the Reserve Bank of India's foreign-exchange framework. So the credit itself is standardised, but the legal and regulatory wrapper around it is not, and that should be checked locally. ## Where a contract workspace helps A letter of credit sits on top of a sale contract, and the trouble usually starts in that contract: the payment clause that names the LC type, the documents list, the shipment and presentation deadlines, and the dates everyone has to hit. Keeping those terms consistent and tracking the deadlines is contract work. Drafting the sale contract behind a letter of credit, reviewing it for a presentation deadline that is too tight or a documents list that will not match, tracking the shipment and presentation windows and governing a run of trade deals can live in one AI workspace tuned to how your company trades. A tool such as Adira is built for this. This explainer alone is enough to understand how a letter of credit works; one workspace just makes the drafting, review and tracking a connected job rather than several scattered ones.