What is a letter of credit?

The deadlock it resolves

Two companies in different countries, no shared legal system, no history, and a container's worth of value at stake. Whoever moves first is exposed. Ship without payment and you may never see the money. Pay without shipment and you may never see the goods.

A letter of credit inserts a bank. The buyer's bank issues an undertaking that it will pay the seller on presentation of specified documents. The seller now has a bank's promise instead of a stranger's, and a bank's promise is a thing that can be relied upon and, if necessary, sued over in a jurisdiction that functions.

The seller's own bank often adds its confirmation, which stacks a second promise on the first, so the seller is relying on a bank in their own country rather than one in the buyer's.

The thing that surprises everyone

The bank pays against documents, not against goods.

If the paperwork conforms exactly to what the letter specifies, the bank must pay, even if the container turns out to hold the wrong thing or nothing at all. If the paperwork has a discrepancy, however trivial, the bank may refuse to pay, even if the goods arrived perfectly.

This is not a flaw. It is the design. Banks are not qualified to inspect industrial machinery in a port, and a system that required them to would not function. So the instrument is deliberately about documents, and everyone in trade finance knows it.

The practical consequence is that a very large share of first presentations contain discrepancies, and much of the work in trade finance is fixing paperwork rather than moving money. A misspelled company name or a date outside the shipping window is enough to stall payment.

What it costs and what it does not cover

It is expensive relative to an open account. There are issuance fees, confirmation fees, amendment fees and discrepancy fees, and the buyer usually has to post collateral or use up a credit line, so the money is committed before anything ships.

It does not protect against goods being defective, late, or not as described. It does not protect against a fraudulent seller who produces perfect documents for a shipment that does not exist, which is a real and recurring fraud. And it does not protect against the buyer simply refusing to accept goods that arrived correctly.

For those, you need inspection certificates written into the required documents, insurance, and a contract. The letter of credit handles the payment risk only, which is one risk among several and rarely the one that actually spoils a deal.

A friend agrees to pay your builder the moment he shows her a signed completion certificate. She is reliable, and she will pay exactly as promised. She has also never visited the house, will never visit the house, and if the certificate is genuine she pays whether or not the kitchen exists.

Where you meet it

Every export contract with a documents clause. Every trade finance conversation that turns out to be about spelling. Every business that discovered its payment terms were a financing decision rather than an administrative one.