Letter of Credit (LC): Meaning, Types & How It Works

A Letter of Credit (LC) is a written undertaking from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer fails to pay, the issuing bank is obligated to cover the full or remaining amount of the purchase. Because international trade involves long distances, different legal systems and unfamiliar counterparties, the LC has become one of the most important payment instruments in cross-border commerce.

In India, LC operations are governed by the Uniform Customs and Practice for Documentary Credits (UCP 600) issued by the ICC, along with RBI’s master directions on trade credits. For working bankers preparing for JAIIB, CAIIB and IIBF certifications, a strong grip on LC concepts is essential — they appear in both Accounting & Finance for Bankers and Bank Financial Management papers.

Parties Involved in a Letter of Credit

• Applicant – the buyer in the transaction who requests the LC.
• Beneficiary – the seller or ultimate recipient of the funds.
• Issuing bank – the bank that opens the LC and promises to pay.
• Advising bank – the bank in the seller’s country that authenticates the LC and helps the beneficiary use it.
• Confirming bank (optional) – adds its own guarantee to the issuing bank’s promise.
• Negotiating bank – the bank that negotiates documents and makes payment to the beneficiary.

For a deeper read on advance-payment LCs, see our linked guide: Red Clause LC and Green Clause Letter of Credit.

How a Letter of Credit Works

The flow of a typical LC transaction is straightforward:

1. Buyer and seller agree on a sale and decide to use an LC.
2. The buyer applies to the issuing bank, which opens the LC in favour of the seller.
3. The LC is transmitted (usually via SWIFT MT700) to the advising bank in the seller’s country.
4. The seller ships the goods and submits the required documents (invoice, bill of lading, insurance, certificate of origin, etc.).
5. If the documents comply with LC terms, the bank releases payment to the seller.
6. The issuing bank then recovers the amount from the buyer.

Types of Letter of Credit

Several variants of the LC have evolved to suit different trade scenarios. Below are the most common types every banker should recognise.

1. Commercial LC

A standard LC, also called a documentary credit. It is the most widely used LC in international trade.

2. Export / Import LC

The same LC is termed differently depending on who is using it. The exporter calls it an export LC, while the importer calls it an import LC.

3. Transferable LC

Allows the beneficiary to transfer all or part of the payment rights to another supplier in the supply chain. This is useful when the beneficiary is merely an intermediary between the actual supplier and the buyer.

4. Un-transferable LC

Does not allow transfer of payment to any third party. The named beneficiary is the only recipient.

5. Revocable LC

Can be altered or cancelled by the issuing bank or buyer at any time without notifying the seller. Such LCs are rarely used today because they offer no protection to the beneficiary. Under UCP 600, all LCs are deemed irrevocable unless explicitly stated otherwise.

6. Irrevocable LC

Cannot be modified or cancelled without the consent of the beneficiary, issuing bank and confirming bank (if any). This is the default form of LC in modern trade.

7. Standby LC (SBLC)

Designed to assure payment if something goes wrong. If the beneficiary proves that the agreed payment was not made, the SBLC becomes payable. It does not facilitate the trade itself — it acts as a financial safety net, similar to a bank guarantee.

8. Confirmed LC

Here, an advising or confirming bank also guarantees payment to the beneficiary, in addition to the issuing bank. Only irrevocable LCs can be confirmed. The beneficiary thus enjoys two independent payment promises.

9. Unconfirmed LC

Backed only by the issuing bank, without a second-bank guarantee. Most LCs in practice are unconfirmed.

10. Revolving LC

Used for multiple shipments / payments under one umbrella LC instead of issuing a new credit for every transaction. It can revolve by time or by value.

11. Back-to-Back LC

Common in transactions involving an intermediary. Two LCs are issued — the first by the buyer’s bank to the intermediary, and a second by the intermediary’s bank to the actual supplier, using the first LC as collateral.

12. Red Clause LC

Allows partial advance payment to the beneficiary before the goods are shipped, against a written undertaking and a receipt from the seller.

13. Green Clause LC

An extension of the Red Clause LC. The advance is paid not only against an undertaking and receipt, but also against proof of warehousing the goods in the exporter’s country.

14. Sight LC

Demands payment on submission of compliant documents. The bank reviews the documents and pays the beneficiary almost immediately if everything is in order.

15. Deferred Payment LC (Usance LC)

Payment is made after an agreed period (e.g., 30, 60 or 90 days after shipment or document presentation). The bank may verify the documents early, but actual payment is delayed.

16. Direct Pay LC

The issuing bank pays the beneficiary directly and then recovers the amount from the buyer. The beneficiary may not interact with the buyer at all.

Why LCs Matter for Bankers in 2026

With India’s merchandise exports continuing to grow and trade finance digitisation picking up pace, LCs remain a core working tool for branch and trade-finance officers. The SWIFT MT700 series, electronic Bills of Lading and platforms like SFMS have made LC processing faster — but the underlying principles of UCP 600 still drive every decision around document examination, discrepancy handling and reimbursement.

Note for exam aspirants: Candidates should verify the latest IIBF circular and UCP / ISBP updates before relying on this list for JAIIB, CAIIB or Certified Credit Professional exams.

Frequently Asked Questions

Q1. What is the main purpose of a Letter of Credit?

An LC reduces payment risk in trade. It assures the seller of payment (since a bank stands behind the buyer) and assures the buyer that payment will be released only when shipping documents are presented as per the agreed terms.

Q2. What is the difference between LC and Bank Guarantee?

An LC is a primary payment mechanism — the bank pays first when documents are compliant. A bank guarantee (including an SBLC) is a secondary obligation — invoked only if the applicant defaults.

Q3. Who pays the LC charges?

Typically, the applicant (buyer) bears the issuing bank’s charges, and the beneficiary (seller) bears the advising / confirming bank’s charges, unless agreed otherwise in the sales contract.

Q4. Which set of rules governs Letters of Credit?

Letters of Credit are governed primarily by UCP 600, supplemented by ISBP 821 for document examination practices, both published by the International Chamber of Commerce.