A letter of credit is a document a bank issues to guarantee that a buyer's payment to a seller will arrive on time and in full, a tool that has quietly kept international trade moving for decades by removing much of the guesswork between strangers doing business across borders.
Why Banks Insert Themselves Into a Simple Payment
Two companies on opposite sides of the planet rarely trust each other on a handshake. Different legal systems, currencies, and thousands of miles of distance make it hard for a seller to know whether a buyer will actually pay once goods ship. A letter of credit solves that by putting a bank between the two parties. The buyer has to show the bank, usually its own, that it holds enough assets or an adequate line of credit to cover the purchase. Once satisfied, the bank issues the letter, and if the buyer later can't pay, the bank covers the gap instead.
Most banks won't take that risk for free. They typically demand collateral, often cash or securities, before agreeing to stand behind the transaction. The letter itself is a negotiable instrument, meaning the issuing bank can pay the seller directly or route payment through another bank it nominates. Some letters are transferable, letting the seller assign the right to collect payment to a parent company or another third party. Internationally, these arrangements run under rules set by the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits.
What a Letter of Credit Actually Costs
Fees are usually calculated as a percentage of the amount the bank is guaranteeing. A common example cited in banking circles is around 0.75% of the guaranteed sum, though the exact rate depends on the bank and the size of the deal. The type of letter matters too. An unconfirmed letter of credit tends to be cheaper. A confirmed one, where a second bank backs the deal, generally costs more because it draws on that second bank's credit strength, but it also tends to speed up how quickly payment moves.
| Type | How It Works | Typical Use | Relative Cost |
|---|---|---|---|
| Commercial | Issuing bank pays the seller directly once required documents, like a bill of lading, are submitted | Standard trade transactions | Moderate |
| Standby | Bank pays only if the buyer fails to meet its obligations | Acts as a backup guarantee, similar to insurance | Varies, often lower unless drawn on |
| Revolving | Allows multiple draws over a set period without redrafting the letter | Ongoing shipments between repeat trading partners | Moderate, spread across multiple transactions |
| Confirmed | A second bank, often the seller's, guarantees payment if the buyer and issuing bank both default | Higher risk international deals | Higher, tied to the issuing bank's credit strength |
| Traveler's | Guarantees that drafts will be honored at specified foreign banks | Individuals traveling abroad | Varies by bank |
Five Main Varieties and When Each Gets Used
A commercial letter of credit is the most straightforward version. The issuing bank pays the seller once it receives the paperwork spelled out in the agreement, cutting the risk of non-payment during a routine transaction. A standby letter of credit flips that logic. Instead of funding the deal itself, it sits in reserve, paying out only if the buyer fails to hold up its end. It functions more like an insurance policy than a payment mechanism.
A revolving letter of credit suits businesses with a recurring relationship, since it allows repeated draws over a period without redrafting paperwork for every shipment. A traveler's letter of credit serves individuals abroad, guaranteeing that foreign banks will honor drafts drawn against it. And a confirmed letter of credit brings in a second bank, typically the seller's, to guarantee payment if both the buyer and the issuing bank fail. Issuing banks usually request this arrangement themselves in cross border deals where risk runs higher. There's also a less common unsecured version, sometimes called a red clause letter of credit, used occasionally in international trade.
How the Paperwork Actually Moves
Take a typical import export deal. The exporter and importer first sign a sales agreement. From there, the importer's bank has to satisfy the exporter and the exporter's bank that its credit is solid enough to proceed. The importer's bank then drafts the letter of credit and sends it to the exporter's bank, which reviews it and passes it along to the exporter once approved.
The exporter ships the goods as specified and submits the required documents to its bank. That bank checks everything against the letter's terms, and if it checks out, forwards the documents to the importer's bank. Payment then flows from the importer's bank to the exporter's bank, and the importer is free to claim the shipped goods. Each step exists to catch problems before money or merchandise moves in the wrong direction.
Where the Trade offs Show Up
The appeal is obvious: letters of credit build trust between parties who might otherwise never do business, and they let both sides define exactly when and how a transaction closes. They can be tailored to fit unusual deal structures, and they tend to make fund transfers more efficient once the terms are set.
The costs usually fall on the buyer, which can make letters of credit an unwelcome expense for cash strapped importers. They also won't catch every possible dispute, since the documents only cover what's written into them, leaving gaps for disagreements the letter never anticipated. Setting one up can be slow and paperwork heavy, and a letter signed today can't account for a political or economic shock that hits before the deal closes.
Citibank's Use in Emerging Markets
Citibank issues letters of credit for buyers across Latin America, Africa, Eastern Europe, Asia, and the Middle East, regions where exporters often struggle to extend credit to buyers directly. By confirming these letters through its own branches, Citibank absorbs country risk and commercial credit risk that individual exporters would otherwise have to shoulder themselves. For sellers operating in economically unstable regions, that guarantee from an established institution can be the difference between closing a deal and walking away from one.
Deciding Whether a Letter of Credit Fits Your Deal
Anyone weighing whether to use a letter of credit has to balance the security it provides against the fees, collateral requirements, and paperwork it demands. For routine domestic transactions between parties with an existing relationship, the added cost may not be worth it. For unfamiliar counterparties, unstable regions, or large one off shipments, the protection often justifies the expense.
Businesses that decide they need one typically start with their existing bank, since most commercial banks offer the service to established customers. Smaller institutions may not have the international network or credit capacity to issue letters efficiently, in which case companies often turn to larger banks like Citibank that specialize in cross border trade finance. The right choice depends on the size of the transaction, the countries involved, and how much risk either party is willing to absorb before money changes hands.
