A new supplier asks for a letter of credit, or your bank suggests one because you are uncomfortable wiring a large deposit overseas. Before you agree to either, understand the one thing that governs everything else about an LC:
A letter of credit pays against documents. It does not pay against goods.
Your bank never sees the cargo. It sees a stack of paper. If the paper matches what the LC says the paper must look like, the bank pays — whether or not the shipment is what you ordered. If the paper does not match, the bank can refuse to pay — whether or not the shipment is perfect. Every decision you make about LCs flows from that.
The mechanics, briefly
Four parties matter:
- Applicant — you, the buyer. You apply to your bank to issue the LC.
- Issuing bank — your bank. It takes on the payment obligation.
- Beneficiary — your supplier. They get paid when they present conforming documents.
- Advising bank — the supplier's bank, which passes the LC to them and usually handles the document presentation.
If your supplier does not trust your bank or your country's banking system, they may ask for a confirmed LC, where a second bank — usually in their market or a major international bank — adds its own promise to pay. Confirmation costs extra and the fee is negotiable as to who absorbs it.
LCs are either at sight (the bank pays when conforming documents arrive) or usance (payment falls due a set number of days after shipment or presentation, giving you a credit period). A usance LC is a financing tool as much as a security tool. A sight LC is purely security.
What an LC does for you
It converts your supplier's incentive. Under a wire-transfer deposit, the supplier has your money and you have a promise. Under an LC, the supplier has a bank's promise and gets nothing until they produce evidence — a transport document, an inspection certificate, a certificate of origin — that they did specific things by specific dates.
That is real. A supplier who cannot produce a clean on-board bill of lading dated before the latest shipment date in the LC does not get paid automatically. You keep control of the money until proof of shipment exists.
It also disciplines the deal. Writing an LC forces both sides to agree, in advance and in writing, on the goods description, quantity, unit price, Incoterm, port pairs, shipment window, partial shipment and transhipment rules, and exactly which documents count as proof. Most of the ugly disputes we see between buyers and new suppliers are disagreements about things nobody wrote down. An LC makes you write them down.
What an LC does not do
- It does not inspect your goods. Banks examine documents on their face. A packing list stating 1,200 units is a conforming document even if the container holds 900.
- It does not confirm the supplier exists in the way you think they do. An LC is not a substitute for verifying an overseas supplier before you commit.
- It does not guarantee delivery. It guarantees payment against documents. Those are different problems. If the supplier simply does not ship, the LC expires unused — you get your collateral back, but you do not get your goods, and you are still dealing with a missed shipment date.
- It does not fix quality. You can require a third-party inspection certificate as a presentation document, naming the inspection company, and that is the single most useful control you can build in. But it only works if the certificate is issued by an independent party you chose, not one the supplier appoints.
- It does not free up your credit. Your bank is taking on a contingent obligation. Expect it to either reduce your operating line by the LC amount or require cash collateral. That is a liquidity cost that does not show up on the fee schedule.
The document set
Exact contents are negotiable, but a typical import LC calls for:
| Document | What it proves | Common trap |
|---|---|---|
| Commercial invoice | Price, quantity, goods description | Description must match the LC wording, not your PO wording |
| Packing list | Carton count, weights, marks | Totals must reconcile to the invoice and transport document |
| Bill of lading or air waybill | Goods were shipped, when, and by whom | "Clean on board" required; notations about damage make it unclean |
| Insurance certificate | Cover exists, in the right amount | Only relevant if you bought on CIF or CIP — see Incoterms |
| Certificate of origin | Origin for duty purposes | An LC document is not a customs origin ruling |
| Inspection certificate | Pre-shipment check happened | Only useful if the inspector is independent |
| Draft / bill of exchange | The payment instrument | Tenor must match the LC |
Keep the list short. Every extra document is another chance to fail.
Discrepancies are the normal outcome, not the exception
Ask any trade finance officer: a large share of first presentations under LCs come back with discrepancies. Common ones are mundane.
- The goods description on the invoice is paraphrased rather than copied from the LC.
- The supplier's name is spelled one way on the LC and another on the bill of lading.
- Documents are presented after the presentation deadline — the LC sets a number of days after the shipment date within which documents must reach the bank, and suppliers routinely miss it.
- The LC expired before presentation.
- Partial shipment was prohibited and the supplier split the order.
- Weights on the packing list do not match the bill of lading.
Here is why this matters to you specifically. When the bank finds a discrepancy, it contacts you for a waiver. At that moment, you have the goods on the water and a decision to make: waive and pay, or refuse. If the goods are fine and you need them, you waive — and you have paid for an instrument that did not ultimately protect you. If something is actually wrong, the discrepancy gives you genuine leverage.
So the discipline is this: read the discrepancy notice properly before you waive. Do not treat it as paperwork. It is the one moment the LC gives you a decision.
And tell your supplier, in writing, before the LC is issued, that they should have their bank pre-check the draft documents against the LC text. Experienced exporters do this. First-timers do not.
Cost, and when the cost is worth it
Banks quote LC fees as issuance or commitment fees on the LC value, usually with a stated minimum, plus amendment fees, document examination fees, courier charges, and confirmation fees if confirmation is required. Ask your bank for its written schedule before you commit to a payment term. Then fold the total into your true landed cost — on a small order, LC costs can be a meaningful share of margin.
An illustrative example with made-up numbers. Suppose a 50,000 CAD order, total bank charges of 900 CAD, and one amendment at 150 CAD. That is 1,050 CAD, or roughly 2.1% of order value. On 10,000 units, about 10.5 cents a unit. On a 300,000 CAD order with the same fixed-ish charges, the percentage drops sharply. Use your own figures — the shape of the relationship is the point. LCs scale badly on small orders and well on large ones.
LC versus deposit and balance
| Letter of credit | Deposit and balance | |
|---|---|---|
| Typical structure | Payment on conforming documents | Deposit on order, balance against copy B/L or on arrival |
| Your money at risk before shipment | None, but collateral or line capacity is tied up | The full deposit |
| Bank cost | Material, with a floor | Wire fees only |
| Admin burden | High — drafting, amendments, examination | Low |
| Protects against non-shipment | Yes, in the sense that you do not pay | No — deposit is gone |
| Protects against wrong goods | Only via inspection certificate | Only via balance withheld until inspection |
| Supplier acceptance | Widely accepted, sometimes preferred | Preferred by most suppliers |
Where each one lands
Reach for an LC when the order is large enough to absorb the cost, the supplier is new or unaudited, the lead time is long, the goods are made to your specification, or the supplier insists on it because they do not know you either. An LC is as much a tool for a nervous seller as a nervous buyer.
Stay with a deposit and balance when the order is small, the supplier is established with you, the lead time is short, or you can structure the balance to fall due against a scanned bill of lading so you are never paying blind. A 30% deposit with 70% against documents through your bank on a documentary collection basis sits usefully between the two — cheaper than an LC, with more control than a straight wire.
The judgement call is the gap between the deposit you would otherwise pay and the full LC cost including tied-up credit. If that gap is small relative to what you would lose if the supplier failed, the LC is cheap insurance. If it is large and you have other ways to reduce risk — staged orders, a pre-shipment inspection you pay for directly, a smaller first order — take those instead.
An LC does not make a bad supplier good. It makes a payment conditional on paperwork, and paperwork is something both competent and incompetent suppliers can produce. Treat it as one control among several, price it honestly into the unit cost, and read the discrepancy notice before you wave it through.