Letter of Credit (L/C) is one of the most widely used payment instruments in international trade, with its core logic beingUsing bank credit to mitigate the distrust between buyers and sellersIn simple terms, the buyer issues a written commitment through a bank, whereby the bank assumes the payment obligation as long as the seller submits documents that comply with the terms of the Letter of Credit (L/C). According to the International Chamber of Commerces Uniform Customs and Practice for Documentary Credits (UCP600), approximately 40% of cross-border trade worldwide is settled using L/Cs, with this proportion reaching as high as 60% in developing countries.

Letter of Credit Operation Process

1. Contract Signing and L/C OpeningThe sales contract stipulates payment by L/C → the buyer (applicant) applies to the local bank for issuance → the issuing bank reviews and issues the letter of credit.
2. Transmission and NotificationThe issuing bank sends the letter of credit (L/C) to the advising bank at the sellers (beneficiarys) location via the SWIFT system → the advising bank verifies its authenticity and then forwards it to the seller.
3. Stock Preparation and Document SubmissionThe seller ships the goods according to the L/C requirements → collects documents such as the Bill of Lading, Invoice, and Packing List → submits the documents to the negotiating bank.
4. Document Review and PaymentThe negotiating bank advances funds after verifying document compliance → forwards the documents to the issuing bank → the issuing bank reimburses the negotiating bank → the buyer pays to redeem the documents and takes delivery of the goods.

The Three Major Advantages of Letter of Credit (L/C)

1. Risk Hedging Mechanism

• For the seller: Payment can be received as long as compliant documents are submitted, avoiding the risk of buyer bankruptcy or refusal to pay;
• To the buyer: Ensure that the goods meet the contract requirements before making payment to prevent seller fraud.

2. Leverage Effect of Financing

• Packing LoanThe seller can advance up to 80% of the payment from the bank with a letter of credit (annual interest rate approximately 4%-6%);
• Negotiation and DiscountingObtain advances from the negotiating bank immediately after document submission, accelerating capital turnover.

3. Global Universality

• UCP600 recognized by 178 countries worldwide, standardized clauses reduce legal conflict risks.

The Four Major Risks of Letter of Credit (L/C)

1. High cost

L/C opening fee (0.1%-0.5% of goods value) + advising fee ($50-$200) + negotiation fee (0.125% of goods value), total cost accounts for about 1%-3% of goods value.

2. The process is complex and time-consuming

Document review takes an average of 5-7 working days, with a discrepancy rate as high as 35%, and the modification cost per order is approximately $200.

3. Soft Clause Trap

For example: The goods must be inspected by personnel designated by the buyer (which deprives the seller of the initiative in document submission).

4. Bank Credit Risk

In 2023, the default rate of letters of credit in emerging markets rose to 1.2%, with a surge in bank refusals due to foreign exchange controls in countries such as Sri Lanka and Argentina.

Risk Response

1. Document Risks

The questionDiscrepancies such as the bill of lading date being later than the letter of credit expiry date or decimal point errors in the invoice amount can lead to refusal of payment.

Countermeasures:

• Use professional document preparation software (such as AEB, EDI systems) to automatically verify data;
• Confirm key information (such as shipping date, cargo description) with the freight forwarder and factory in advance.

1. 2. Clause Risk

The questionAmbiguous clauses (such as applicable law determined by the issuing bank) may lead to disputes.

Countermeasures:

• Require the deletion of non-documentary conditions (such as the goods must be satisfactory to the buyer);
• Adhere to using SWIFT MT700 standard format for issuing letters of credit, avoiding handwritten additional clauses.

3. Bank Risk

The questionSome banks have insufficient creditworthiness or deliberately pick on discrepancies.

Countermeasures:

• Priority is given to letters of credit issued by internationally recognized banks;
• Insure with China Credit Insurances Letter of Credit Insurance to cover risks of bank bankruptcy or unreasonable refusal of payment.

4. Political Risk

The questionWar and foreign exchange controls have caused payment obstacles.

Countermeasures:

• Choose an Irrevocable Letter of Credit (Irrevocable L/C) and add confirmation (Confirmed L/C);
• Diversify settlement currencies (e.g., using Euro, RMB to hedge against USD risks).

Alternative Solutions and Combination Strategies for Letters of Credit

1. Mixed Payment

30% T/T advance payment + 70% L/C reduces the buyers financial pressure while protecting the sellers rights.

2. Backup Plan

For high-credit buyers, it can be converted to open account (OA), but it needs to be paired with export credit insurance (maximum compensation ratio of 90%).

3. Digital Transformation:

By adopting blockchain-based Letters of Credit (L/C), the document review time has been reduced from 7 days to 24 hours, with costs lowered by 30%.

Conclusion

Letters of Credit (L/C) serve as both a safety valve for international trade and a touchstone for testing a companys risk control capabilities. It is recommended that enterprises establish three lines of defense:

1. Front-end negotiationStrictly review the terms of the Letter of Credit (L/C) and reject ambiguous expressions;
2. Mid-range ExecutionStandardize the document preparation process and introduce third-party document review services;
3. Backend fallbackPurchase credit insurance and reserve a budget for legal proceedings.

With the development of financial technology, letters of credit (L/C) are evolving from paper documents to digital formats, but the core logic remains unchanged. Only by rigorously adhering to the details of the rules can one navigate global trade steadily and successfully. Finally, if you need more support in your import and export trade, please feel free to contact us!