What Is a Letter of Credit?

A European manufacturer agrees to supply $8 million of specialized industrial equipment to a first-time buyer in Sub-Saharan Africa. The African buyer cannot prepay without materially constraining project liquidity and shifting execution risk entirely onto its balance sheet. The European exporter, facing long production lead times and limited recourse in the buyer’s jurisdiction, is unwilling to ship without assurance that payment will be made once contractual obligations are met. Absent a mechanism that aligns payment with performance and allocates risk appropriately, the transaction is at an impasse.

In theory, several payment structures could bridge this gap. Cash-in-advance would eliminate exporter risk but would tie up the buyer’s capital and shift all execution risk upstream. Open-account terms would preserve buyer liquidity but leave the exporter exposed to non-payment, currency controls, and enforcement risk. Documentary collections would provide some procedural discipline but offer no payment guarantee if the buyer fails to honor documents at maturity. Bank guarantees or standby instruments could partially address performance risk, but often lack the transactional specificity required for complex, made-to-order shipments.

The transaction instead proceeds under a confirmed, 90-day usance Letter of Credit (LC). Upon issuance of the LC, the exporter receives a bank-backed undertaking that payment will be made once shipment documents strictly comply with agreed terms. With this assurance in place, the exporter begins production and is able to arrange pre-shipment financing against the LC to fund inputs and manufacturing during the build phase.

Three months later, once the equipment is completed and shipped, the exporter presents compliant documents to the confirming bank and discounts the LC, accelerating cash receipt shortly after shipment. The importer takes delivery of the equipment while payment is deferred for 90 days from shipment, allowing installation and commissioning to begin before funds are released. Payment is ultimately made only after documentary compliance, aligning production, shipment, delivery, and cash flow across both parties.

Rather than relying on counterparty creditworthiness or cross-border legal enforcement, the Letter of Credit substitutes bank credit and standardized rules for bilateral trust, sequencing risk and liquidity over time instead of forcing either party to absorb it upfront.

In practice, Letters of Credit are most commonly used where counterparties lack a long operating history, transact across jurisdictions with uneven legal enforcement, or face material production, shipping, or political risk. While procedurally heavier than open-account trade, they persist because they reallocate risk, reshape liquidity timing, and impose execution discipline in ways few other payment mechanisms can.

Risk Allocation and Control

The defining feature of a Letter of Credit is how it reallocates risk across the transaction.

For the exporter, the LC replaces buyer credit risk with bank risk. Once compliant documents are presented, payment is due regardless of disputes over goods, performance, or downstream use. In the opening case, this shift is decisive: the European exporter proceeds to manufacture and ship the equipment to Africa not because it trusts the buyer, but because it relies on the payment undertaking of the issuing and confirming banks.

This substitution materially reduces exposure to buyer default, political interference, and transfer restrictions, and largely eliminates the need for independent credit assessment of an unfamiliar counterparty. For customized or hard-to-resell equipment, a properly structured LC also protects against pre-shipment cancellation once production has commenced.

For the importer, risk is managed through conditionality. Funds are released only after documentary compliance, ensuring shipment occurs within agreed commercial parameters. Rather than relying on bilateral trust or post-shipment remedies, the importer benefits from bank-level document examination conducted under standardized rules, reducing ambiguity and limiting opportunistic behavior on either side.

LCs do not eliminate risk entirely. Execution risk can still arise from shipment windows that fail to reflect realistic production timelines, documentary requirements ill-suited to project cargo, or inspection and certification clauses that introduce third-party bottlenecks late in the process. Even minor discrepancies, such as mismatched dates between transport documents and invoices, can delay payment or require waivers. As a result, the effectiveness of an LC depends less on its mere presence than on how precisely it is structured.

Liquidity and Working Capital Implications

Beyond risk transfer, LCs materially reshape how liquidity moves through a transaction.

For exporters, an issued LC often converts a purchase order into a financeable asset. Once in hand, exporters can secure pre-shipment financing to fund inputs, production, or logistics. After shipment, compliant documents can be negotiated or discounted, accelerating cash conversion. Advance rates of 60–90% of invoice value are common for confirmed LCs, depending on tenor and counterparty risk.

For importers, LCs preserve liquidity relative to cash-in-advance terms. Sight LCs (payable upon compliant document presentation) delay payment until shipment, while usance LCs (with payment deferred after shipment) extend payment further, typically 30 to 180 days post-shipment. This allows importers to align cash outflows with installation, resale, or receivables collection, rather than front-loading capital.

These liquidity benefits come at a cost. LC-related fees and charges scale with transaction size, tenor, and perceived risk, effectively pricing the ability to defer payment or accelerate cash receipt. As a rule of thumb, issuance, confirmation, and document handling costs often amount to approximately 1–3% of transaction value on an annualized basis, before any financing or discounting costs. Where counterparties have deep trust and short cash-conversion cycles, this cost and complexity may outweigh the benefits. In cross-border or project-driven transactions, however, using an LC can be the difference between execution and stalemate.

Operational Discipline and Execution

Letters of Credit impose structure on transactions that might otherwise depend on informal coordination or post-shipment negotiation.

By requiring shipment terms, International Commercial Terms (Incoterms), documentation, insurance, and inspection criteria to be defined upfront, LCs reduce ambiguity and enforce execution discipline. These advantages of LCs are amplified where counterparties operate across different legal systems and commercial norms.

Many exporters, particularly in capital-intensive or higher-risk markets, will only ship against cash in advance or a bank-backed Letter of Credit. By using an LC, importers gain access to a broader universe of suppliers who would otherwise be unwilling to transact on open-account or collection terms.