A commercial letter of credit acts as a means of ensuring payment to a seller upon
shipment of goods to a buyer. Although letters of credit are used to effect payment
for domestic transactions, the majority are used to settle payments in international
trade. Typically letters of credit are issued in freely negotiable form and require
presentation of documents which describe the commercial transaction, evidence shipment,
and transfer title.
Purpose & Undertaking
A letter of credit allows a seller to base the credit decision on the financial
soundness and stature of a bank.
- The buyer may use the letter of credit as a method of financing purchases or to
assure compliance with shipment dates, quantities, and receipt of critical documents.
- The banks involved in the issuance, advising and negotiation of commercial letters
of credit provide a service to their customers and act as agents in the buying and
selling process.
- Banks operate strictly within standards and guidelines established for letters of
credit. Nearly every letter of credit issued is subject to the Uniform Customs and
Practices for Documentary Credits, Publication No. 500 of the International Chamber
of Commerce.
Underlying Contract
The transaction which gives rise to a letter of credit is usually a commercial contract
(purchase order, sales contract, pro forma invoice, etc.) in which the buyer agrees
to purchase a certain product or service from the seller at a specified price and
under specified conditions. These conditions outline the terms of sale, date of
delivery, and other common commercial considerations. This contract of sale, while
remaining distinctly separate, is then used to establish the terms of the letter
of credit (see figure below).
The issuing bank transmits the letter of credit to the advising US
bank.