Commercial finance · Trade instruments
Letters of credit: bank-backed payment assurance for international suppliers
A letter of credit is an undertaking by a bank to pay a supplier when the supplier presents documents that comply with the credit's terms. It assures payment without, by itself, lending money. Ocean Capital Exchange introduces businesses to third-party providers able to arrange letters of credit.
Definition
What a letter of credit is
A letter of credit is a documentary undertaking in which an issuing bank, acting for a buyer, commits to pay the seller a stated amount when the seller presents specified documents that strictly comply with the credit's terms.
For the buyer, it is a contingent liability rather than a loan: the bank pays only if compliant documents are presented, and the buyer must then reimburse the bank. Funding to meet that reimbursement is a separate matter.
Banks may require the buyer to hold cash collateral against the credit, or to have an approved facility, before issuing.
At a glance
- Provides
- A bank undertaking to pay a supplier against documents
- Nature for buyer
- Contingent liability; not automatic lending
- Costs
- Commissions and document fees; quote-specific
- Collateral
- Cash collateral or a facility may be required
- Key risk
- Documentary discrepancies and full reimbursement obligation
- OCE's role
- Introducer to third-party providers; does not issue instruments
Suitability
Which businesses it tends to suit
Letters of credit suit trades where the supplier needs assurance before shipping.
Usually a fit
- Importers whose overseas suppliers require bank-backed payment assurance.
- New supplier relationships where trust has not yet been established.
- Larger shipments where the supplier will not ship on open account.
- Businesses able to manage precise documentary requirements.
Usually not a fit
- Businesses needing funding rather than assurance; trade finance may fit better.
- Small, frequent purchases where costs outweigh the benefit.
- Suppliers who already trade on open account.
- Businesses unable to provide collateral or meet bank requirements.
Process
How a letter of credit works
A documentary credit follows a defined sequence.
- 01
Terms agreed
Buyer and supplier agree to use a letter of credit and the required documents.
- 02
Application
The buyer applies to the issuing bank, which assesses it and may require collateral.
- 03
Credit issued
The bank issues the credit, often advised to the supplier through a bank in the supplier's country.
- 04
Goods shipped
The supplier ships and prepares the required documents.
- 05
Documents examined
Banks check that documents strictly comply with the credit.
- 06
Payment and reimbursement
On compliant presentation the bank pays the supplier, and the buyer reimburses the bank.
Banks deal in documents, not goods. A compliant presentation can trigger payment even if the goods later prove unsatisfactory.
Comparison
Letter of credit compared with trade finance
They are often confused but do different jobs.
| Letter of credit | Trade finance | |
|---|---|---|
| Purpose | Payment assurance to the supplier | Funding to pay the supplier |
| Cash advanced? | Not by itself | Yes |
| Buyer's exposure | Contingent liability to reimburse the bank | Debt to repay the provider |
| Main costs | Commissions, document fees, possible collateral | Time-based charges plus fees |
In practice
Typical uses
Common uses include:
- New overseas supplier
- Giving assurance on a first order.
- High-value shipments
- Where open account is not acceptable to the supplier.
- Specified documentation
- Ensuring inspection, origin or insurance documents are provided before payment.
- Supporting negotiations
- Securing supply where competitors cannot offer assurance.
- Credit face valueAssumed figure
- £200,000
- Commission at an assumed 2% a year for 120 days£200,000 × 2% × 120 ÷ 365
- £1,315.07
- Assumed fixed feesFor example issuance and document fees
- £350.00
- Estimated cost of the credit
- £1,665.07
- Contingent exposurePayable to the bank if compliant documents are presented
- £200,000
- Cash collateral at an assumed 20%Held by the bank; not a cost and not borrowing
- £40,000
Hypothetical arithmetic only. The commission rate, fees and collateral percentage are assumptions, not typical or offered terms. Commission is not borrowing interest. The exposure and collateral are shown separately from cost; this is not a loan repayment.
Weighing it up
Benefits and material limitations
Letters of credit add assurance and administration in equal measure.
Benefits
- Supplier assurance
- May secure supply that would otherwise require prepayment.
- Payment tied to documents
- The supplier is paid only on compliant presentation.
- Defined conditions
- You can specify documents required before payment.
Material limitations
- Documents, not goods
- Compliant documents trigger payment even if goods disappoint.
- Full reimbursement
- You must reimburse the bank for any payment.
- Collateral
- Cash may be tied up as collateral for the life of the credit.
- Discrepancies
- Errors in documents cause delays and extra charges.
- Costs
- Commissions and fees apply whether or not the credit is drawn.
- Not funding
- You still need cash or a separate facility to reimburse the bank.
Due diligence
What banks and providers assess
Each issuing bank applies its own criteria. Areas commonly reviewed include:
- Buyer's credit standing
- Ability to reimburse the bank.
- Transaction
- Goods, value, supplier and countries involved.
- Collateral
- Cash or facilities available to support the credit.
- Compliance checks
- Sanctions, trade and know-your-customer screening.
- Documentation
- Clarity of the proposed documentary terms.
Information often requested
- Pro-forma invoice or sales contract
- Supplier details
- Recent accounts and management accounts
- Details of existing facilities
Indicative only. Banks set their own requirements. Ocean Capital Exchange does not issue letters of credit or make credit decisions.
Pricing structure
Costs and settlement
Pricing is quote-specific. Typical components:
- Issuance commission
- Often calculated on face value for the validity period.
- Amendment fees
- For changes to the credit after issue.
- Discrepancy fees
- Charged where documents do not comply.
- Advising and confirmation fees
- Charged by other banks involved, which may be payable by either party.
- Cash collateral
- Not a fee, but cash held by the bank that you cannot use.
Repayment and settlement
- There is no loan repayment unless separate funding is drawn.
- If compliant documents are presented, you must reimburse the bank for the amount paid.
- Collateral is usually released when the credit expires or is settled.
- Usance (deferred payment) credits defer the payment date but not the obligation.
Checklist for comparing quotes
- 1.Commission basis and validity period
- 2.All fixed and discrepancy fees
- 3.Collateral requirement
- 4.Who pays advising and confirmation fees
- 5.Reimbursement terms
- 6.Applicable rules and documentary terms
Cost and exposure illustration
Estimate the cost and exposure of a letter of credit
Enter the credit's face value, an annual commission rate from a quote, the validity in days, any fixed fees and the cash-collateral percentage a bank requires. The tool calculates commission as face value × rate × days ÷ 365 plus fixed fees, and shows the contingent exposure and indicative cash collateral separately. This is not borrowing interest and no loan repayment is shown. Fields start blank.
Illustrative result
Complete every field to see a result.
0 of 5 required figures entered
Ocean Capital Exchange is an introducer, not a lender or issuing bank. Check the actual repayment schedule, all charges and security obligations with the provider before committing.
Want to discuss these figures? Open our enquiry form (opens in a new tab). Calculator figures are not transferred automatically, so please include any you want us to review.
Letter of credit questions
Still unsure? Call +44 20 7183 2026.
Is a letter of credit a loan?
No. It is a bank undertaking to pay your supplier against compliant documents. You must reimburse the bank, but no money is lent unless a separate facility is drawn.
What is a contingent liability?
An obligation that becomes payable only if an event occurs; here, the presentation of compliant documents.
Why might a bank require cash collateral?
To secure your obligation to reimburse it. The bank decides whether and how much.
What happens if documents do not match?
Discrepancies can delay payment and incur fees. You may be asked to waive them, which removes some protection.
Does a letter of credit guarantee the goods are as ordered?
No. Banks examine documents, not goods. Specifying inspection certificates can help.
What is a confirmed letter of credit?
One where a second bank, often in the supplier's country, adds its own payment undertaking, at extra cost.
How is it different from trade finance?
Trade finance lends money to pay suppliers; a letter of credit gives assurance of payment. They can be combined.
Independent background reading
These independent sources explain general concepts. They do not endorse Ocean Capital Exchange or confirm our providers, product availability or terms. Your provider’s agreement takes precedence over an illustration.
Important information
Ocean Capital Exchange Ltd introduces businesses to third-party providers of letters of credit and trade instruments. We are not a lender, do not make credit decisions and do not guarantee that finance will be offered or on what terms. Any facility is subject to the provider's own assessment, due diligence, approval and documentation.
A letter of credit creates an obligation to reimburse the issuing bank in full if compliant documents are presented.
This page is general information, not financial, legal or tax advice. Worked examples and calculator results are hypothetical arithmetic based on assumed or visitor-entered figures; they are not quotes, offers or typical terms. Business finance may require security or personal guarantees. Read any agreement carefully and take independent advice where appropriate.
Discuss supplier payment assurance
Tell us about your supplier, shipment and timing. We can explain how a letter of credit works and introduce suitable providers.
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- +44 20 7183 2026
- Office
- 73 Watling Street, London, EC4M 9BJ