Letters of Credit Explained: How a Documentary Credit Works
Letter of credit explained under UCP 600: the parties, the step-by-step flow, the 5-banking-day and 21-day rules, costs, and a worked example for exporters.
Key takeaways
- A letter of credit is the issuing bank's irrevocable undertaking to pay the seller against a complying presentation of documents.
- Banks deal with documents, not goods, and the credit is independent of the sales contract: the seller is paid if the documents comply, whatever happens to the goods.
- Under UCP 600 a bank has a maximum of five banking days after the day of presentation to examine documents, and the original transport document must be presented within 21 days after shipment, unless the credit states otherwise, and before expiry.
- The advising bank only checks the credit's apparent authenticity; only a confirming bank adds its own undertaking to pay.
- Read every new credit the day you receive it and ask for amendments before shipping if any term is impossible to meet.
A letter of credit, or documentary credit, solves the oldest problem in trade: a seller who will not ship without being sure of payment, and a buyer who will not pay without being sure of shipment. It replaces both promises with a bank's: the buyer's bank undertakes to pay the seller as soon as the seller presents documents showing it has shipped as agreed.
That undertaking is powerful but strict. The bank pays against documents, not goods, and only if the documents comply exactly with the credit's terms, read under the ICC's rules. Exporters who understand those rules get paid within days of presenting; exporters who do not, discover that a letter of credit with a mistake in it is worth little more than a collection.
This lesson explains what a letter of credit is under UCP 600, the role of each bank, the full step-by-step flow, the deadlines that decide whether you are paid, what it costs, and what to check on the day the credit arrives. The variants (confirmed, standby, transferable and others) are covered in the kinds of letters of credit, and the errors that block payment in letter of credit discrepancies.
What is a letter of credit?
A letter of credit is an arrangement by which a bank, the issuing bank, acting at the request of its customer, the applicant (the buyer), gives the beneficiary (the seller) an irrevocable undertaking to honour a complying presentation of documents.
"Honour" has a precise meaning in UCP 600. Depending on how the credit is available, it means to pay at sight, to incur a deferred payment undertaking and pay at maturity, or to accept a bill of exchange drawn by the beneficiary and pay it at maturity.
UCP 600 and ISBP 821: the rules behind the credit
Letters of credit are not governed by an international treaty but by rules written by the International Chamber of Commerce:
- UCP 600, the Uniform Customs and Practice for Documentary Credits, ICC Publication No. 600, in force since 1 July 2007. It applies when the credit expressly states that it is subject to it, which virtually every credit does. Its articles can be modified or excluded by the credit itself.
- ISBP 821, International Standard Banking Practice, published by the ICC in 2023 to replace ISBP 745. It explains how examiners apply UCP 600 to each type of document, and is the reference used to decide whether a document complies.
- eUCP, a supplement to UCP 600 for the presentation of electronic records, used when the credit allows it.
Two principles of UCP 600 drive everything else:
- Independence: the credit is a separate transaction from the sales contract. Banks are not concerned with or bound by the contract, even if the credit refers to it.
- Documents, not goods: banks deal with documents and not with the goods, services or performance to which the documents relate.
Who are the parties to a letter of credit?
| Party | Who it is | What it does under UCP 600 |
|---|---|---|
| Applicant | The buyer | Asks its bank to issue the credit and reimburses it |
| Beneficiary | The seller | Ships and presents the documents |
| Issuing bank | The buyer's bank | Irrevocably undertakes to honour a complying presentation |
| Advising bank | A bank in the seller's country, usually a correspondent | Checks the apparent authenticity of the credit and forwards it; no undertaking to pay unless it also confirms |
| Nominated bank | The bank with which the credit is available, or any bank if available with any bank | Authorised to honour or negotiate, but not obliged to unless it has confirmed or expressly agrees |
| Confirming bank | Usually the advising bank, at the issuing bank's request | Adds its own definite undertaking to honour or negotiate a complying presentation |
A credit must state the bank with which it is available, or that it is available with any bank, and how: by sight payment, deferred payment, acceptance or negotiation. It must also state an expiry date for presentation. A credit must not be issued available by a bill of exchange drawn on the applicant.
How does a letter of credit work, step by step?
- Contract: buyer and seller agree on payment by letter of credit, with its key terms: amount, type, confirmation, documents, latest shipment date, expiry, who pays which charges.
- Application: the buyer applies to its bank to issue the credit. The bank checks the buyer's credit line and may block a cash margin.
- Issuance: the issuing bank sends the credit by SWIFT to the advising bank in the seller's country.
- Advice: the advising bank checks apparent authenticity and advises the credit to the seller. If asked to, and if it accepts the risk, it adds its confirmation.
- Review: the seller checks every term and asks for amendments if needed, before producing or shipping.
- Shipment: the seller ships and obtains the transport document and the other documents required.
- Presentation: the seller presents the documents to the nominated bank or the confirming bank, within the presentation period and before expiry.
- Examination: the bank examines the documents and decides within five banking days whether the presentation complies.
- Honour: if the presentation complies, the confirming bank or the issuing bank honours it, at sight or at maturity; a nominated bank that negotiates advances the funds to the seller.
- Reimbursement: the documents travel to the issuing bank, which reimburses the nominated or confirming bank, debits the buyer, and releases the documents so the buyer can collect the goods.
The deadlines that decide whether you get paid
| Rule | What it says | Where |
|---|---|---|
| Examination time | Each bank has a maximum of five banking days following the day of presentation to determine if the presentation complies | UCP 600 art. 14(b) |
| Presentation period | Original transport document presented not later than 21 calendar days after the date of shipment, unless the credit sets another period, and never after expiry | UCP 600 art. 14(c) |
| Latest shipment date | Set by the credit; not extended if it falls on a bank holiday | UCP 600 art. 29 |
| Expiry date | Last day for presentation at the stated place; extended to the next banking day if the bank is closed for reasons other than force majeure | UCP 600 art. 6 and 29 |
| Notice of refusal | One single notice listing all discrepancies, by the end of the fifth banking day | UCP 600 art. 16 |
Other rules every exporter should know:
- Tolerances: "about" or "approximately" before an amount, quantity or unit price allows 10% more or less; when the quantity is not stated in packing units or individual items, a 5% tolerance on quantity applies as long as the amount drawn does not exceed the credit (UCP 600 art. 30).
- Partial shipments are allowed unless the credit prohibits them (art. 31).
- Insurance, when required, must cover at least 110% of the CIF or CIP value if the credit says nothing else, and be dated no later than the date of shipment, unless it shows that cover takes effect from that date at the latest (art. 28).
- The commercial invoice must appear to be issued by the beneficiary, be made out in the name of the applicant and in the currency of the credit, and describe the goods as the credit does; it need not be signed (art. 18).
What does a letter of credit cost?
Fees vary widely by bank and country; the figures below are indicative ranges only.
| Charge | Paid by (usual practice) | Indicative level |
|---|---|---|
| Issuing commission | Buyer | Often 0.1 to 0.5% per quarter of validity, with a minimum |
| Amendment fee | The party requesting the amendment | Flat fee per amendment |
| Advising fee | Seller | Flat fee, often USD 50 to 200 |
| Confirmation commission | Seller, unless agreed otherwise | From about 0.1% a year for first-class banks in low-risk countries to several percent for high-risk ones |
| Payment, acceptance or negotiation commission | Seller | Around 0.1 to 0.25% of the amount drawn |
| Discrepancy fee | Seller, deducted from the proceeds | Flat fee per discrepant presentation, often USD 50 to 150 |
| Deferred payment or acceptance commission | As agreed | Per month or per quarter until maturity |
Worked example: olive oil to Dubai under a letter of credit
An Algerian olive oil producer sells 2 containers of extra virgin olive oil to a distributor in Dubai for USD 120,000, CFR Jebel Ali. The contract requires an irrevocable credit, payment at sight, confirmed by a bank in Algeria, charges outside the UAE for the beneficiary's account.
- The credit is issued on 2 March 2026: latest shipment date 15 April 2026, expiry 10 May 2026 in Algeria, presentation period not stated, partial shipments prohibited.
- Documents required: commercial invoice in 3 copies, full set of clean on-board bills of lading to the order of the issuing bank, packing list, certificate of origin, health certificate.
- The goods are loaded and the B/L shows an on-board date of 8 April 2026. Last day to present: 29 April 2026 (21 days after shipment, and before expiry).
- The exporter presents on 20 April. The confirming bank examines within five banking days, finds the presentation complying and pays.
Charges for the exporter: advising USD 120, confirmation at 0.6% for the period, so USD 720, payment commission 0.15%, so USD 180, plus SWIFT and courier fees of about USD 100. Total about USD 1,120, or 0.9% of the sale, which the exporter priced in from the start.
What to check when you receive a letter of credit
- Names and addresses of applicant and beneficiary are correct.
- Amount, currency, tolerance and the Incoterms® 2020 rule match the contract.
- The credit is subject to UCP 600, is available where you can present, and its expiry place is in your country.
- Latest shipment date and expiry leave you enough time, including for production, booking and document preparation.
- Ports, partial shipments and transhipment terms match the real routing.
- Every required document is one you can obtain, from the issuer named, in the form required.
- No condition depends on the buyer, such as an inspection certificate signed by the applicant.
- The confirmation, if agreed, is actually added, and the charges clause matches the contract.
Letters of credit and exchange control
Some countries make the letter of credit compulsory or preferred for certain trade flows. Algeria's 2009 Supplementary Finance Law (article 69) imposed the documentary credit as the only method for paying imports; the 2014 Finance Law (article 81) reinstated the documentary collection alongside it. Your bank will also process export and import credits through bank domiciliation. Rules evolve: confirm with your bank what applies to your operation.
Common mistakes
- Accepting the credit without reading it and discovering at presentation that a document is impossible to obtain.
- Confusing advising with confirmation and assuming a bank in your country will pay.
- Missing the 21-day presentation period because the documents arrived late from the forwarder.
- Letting the buyer insert conditions that only the buyer can fulfil.
- Shipping after the latest shipment date in the hope that the buyer will accept.
- Forgetting the bill of exchange when the credit is available by acceptance or negotiation with drafts.
Frequently asked questions
How does a letter of credit work in simple terms?
The buyer asks its bank to issue a credit in favour of the seller. The seller ships the goods and presents the documents listed in the credit to a bank. If the documents comply with the credit's terms, the issuing bank, or a confirming bank, must pay, whether or not the buyer still wants the goods.
How long does a bank have to check documents under a letter of credit?
Under UCP 600 article 14, each nominated bank, confirming bank and the issuing bank has a maximum of five banking days following the day of presentation to decide whether the presentation complies. If it refuses, it must send a single notice listing all discrepancies by the end of that fifth banking day.
What is the 21-day rule in a letter of credit?
If a credit requires an original transport document, it must be presented by or on behalf of the beneficiary not later than 21 calendar days after the date of shipment, unless the credit sets another period, and in any case not later than the expiry date of the credit.
Is a letter of credit irrevocable?
Yes. Under UCP 600 a credit is irrevocable even if it does not say so. It cannot be amended or cancelled without the agreement of the issuing bank, the confirming bank if any, and the beneficiary.
Who pays for a letter of credit?
Usually the buyer pays the issuing bank's charges and the seller pays the advising, confirming and payment charges of banks in its own country, but the credit itself states which charges are for the beneficiary's account. The split should be agreed in the sales contract before the credit is opened.