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Strategic Management and Corporate Finance · Raising of Funds - Non Fund Based

Letter of Credit: Types, Parties and Process

Updated 11 October 2026 · Fact-checked

A **letter of credit (LC)** is a written undertaking by a bank, issued at the buyer's request, to pay the seller a stated sum if the seller presents documents that comply with the LC terms. It is a non-fund based facility. To answer questions, name the parties, the type, the steps and the documents.

Understand Letter of Credit

A letter of credit solves a trust problem. A seller in one place does not want to ship goods before being sure of payment. A buyer elsewhere does not want to pay before goods are shipped. The bank steps in. It replaces the buyer's promise with its own promise to pay.

It is called non-fund based because the bank does not lend money at the start. It gives a commitment. Funds move only if the seller presents compliant documents. If the buyer cannot pay on that date, the bank pays and the bank's exposure becomes a funded one, usually recovered from the buyer.

The LC is a separate contract from the sale contract. Banks deal in documents, not goods. The bank checks whether the documents match the LC terms on their face. It does not check whether the goods are good. This is the independence principle and it is the core idea in examination answers.

Most international LCs follow UCP 600, the Uniform Customs and Practice for Documentary Credits, issued by the International Chamber of Commerce. It applies only when the LC says it is subject to UCP 600. It sets rules on definitions, irrevocability, examination of documents and time limits.

The parties are:

  • Applicant: the buyer/importer who asks for the LC.
  • Issuing bank: the buyer's bank that issues the LC.
  • Beneficiary: the seller/exporter who is paid.
  • Advising bank: usually in the seller's country; it authenticates and passes on the LC without a payment promise of its own.
  • Confirming bank: a bank that adds its own undertaking to pay, on the issuing bank's request or authorisation.
  • Nominated bank: the bank authorised to pay, accept or negotiate under the LC.

Key rules to remember

Core principle of an LC
Bank pays if: documents presented are complying, within expiry date and presentation period
Banks deal in documents, not goods, services or performance.
Irrevocability under UCP 600
A credit is irrevocable even if it does not say so
Amendment or cancellation needs agreement of issuing bank, confirming bank (if any) and beneficiary.
Presentation period under UCP 600
Presentation within 21 calendar days after shipment date, and not later than LC expiry
Applies unless the LC states a different period.
Examination time for banks
Maximum 5 banking days following the day of presentation
Bank decides whether the presentation complies or is to be refused.
Types in one line
Sight / Usance, Revocable-type not used / Irrevocable, Confirmed / Unconfirmed, Transferable, Revolving, Back-to-back, Red clause, Standby
Be ready to define each in two lines.

How to solve Letter of Credit questions

Use this method for any question on letters of credit, whether it asks for a definition, a process, a type comparison or a case.

  1. 1Define the LC in one line: a bank's undertaking to pay the beneficiary against complying documents, at the applicant's request.
  2. 2Identify the parties in the facts: applicant, issuing bank, beneficiary, advising or confirming bank.
  3. 3Identify the type: sight or usance, confirmed or unconfirmed, revolving, standby, transferable, back-to-back.
  4. 4Set out the process in order: sale contract, application, issue, advising, shipment, document presentation, scrutiny, payment, reimbursement, release of documents to buyer.
  5. 5Apply the independence principle and UCP 600 to the facts, checking documents, dates and discrepancies.
  6. 6Conclude with the outcome and the benefit or risk for buyer, seller and bank, as asked.

Quickest way: Parties-Type-Process-Principle (PTPP)

When to use it: Use when you have few minutes and need a structured answer to a short or medium question.

  1. P: list the parties with one-line roles.
  2. T: state the type asked and one distinguishing feature.
  3. P: give the process in 6-8 numbered points.
  4. P: close with the principle: documents, not goods, and UCP 600 governs.

Common mistakes in Letter of Credit

  • Saying the advising bank guarantees payment.

    Students assume any bank named in the LC is liable.

    Fix: The advising bank only authenticates and forwards the LC. Payment assurance comes from the issuing bank, or from a confirming bank that has added its confirmation.

  • Saying the bank checks the quality of goods.

    It seems natural that payment depends on goods arriving properly.

    Fix: Write that banks examine documents on their face against LC terms. Quality disputes are settled under the sale contract.

  • Mixing up revolving and standby LCs.

    Both are used for repeated or backup support, so they sound alike.

    Fix: A revolving LC renews or reinstates its amount for repeated shipments between the same parties. A standby LC is a backup, paid only if the applicant fails to perform or pay.

  • Confusing sight and usance LCs.

    Both involve documents and payment, so the timing difference is forgotten.

    Fix: Sight LC: payment on presentation of complying documents. Usance LC: payment at a stated later date, such as 60 or 90 days, usually against an accepted draft.

  • Ignoring discrepancies in documents.

    Case answers often focus only on the process.

    Fix: Check dates, amounts, descriptions and missing documents. A non-complying presentation can be refused, unless the applicant waives the discrepancy.

  • Treating the LC as part of the sale contract.

    The two are linked in practice.

    Fix: State that the LC is a separate contract, independent of the sale contract.

Worked examples

Example 1

Explain the working of a documentary letter of credit in an import transaction, from the sale contract to payment.

Show the solution
  1. Buyer and seller agree a sale contract with payment by LC.
  2. The buyer (applicant) applies to its bank to issue an LC in favour of the seller (beneficiary).
  3. The issuing bank issues the LC and sends it through an advising bank in the seller's country, which authenticates it.
  4. The seller checks that the LC terms match the sale contract and asks for amendments if they do not.
  5. The seller ships the goods and collects documents such as the invoice, bill of lading, packing list and insurance certificate.
  6. The seller presents the documents to the nominated bank within the presentation period and before expiry.
  7. The bank examines the documents against the LC terms. If they comply, it pays, accepts or negotiates as the LC provides.
  8. The documents go to the issuing bank, which reimburses the nominated bank.
  9. The buyer pays or reimburses the issuing bank and receives the documents to take delivery of the goods.

Answer: The LC works as a bank undertaking: the issuing bank pays the seller against complying documents, and the buyer then reimburses the bank and gets the documents. Banks deal only in documents.

Example 2

An LC allows shipment up to 10 June 2027 and requires presentation within 21 days after shipment. Goods are shipped on 4 June 2027 and the LC expires on 30 June 2027. By which date must the seller present documents?

Show the solution
  1. Shipment date is 4 June 2027.
  2. Adding 21 calendar days gives 25 June 2027.
  3. The LC expiry date is 30 June 2027.
  4. Presentation must be within 21 days after shipment and not later than expiry.
  5. The earlier of 25 June and 30 June is 25 June 2027.

Answer: The seller must present complying documents by 25 June 2027.

Exam tips

  • Draw or list the parties first. Many case questions are solved once roles are clear.
  • Write the process as numbered steps. Examiners reward sequence.
  • For comparison questions, use two or three points: purpose, trigger for payment and use case.
  • Quote UCP 600 principles only as far as you are sure: irrevocability, documents-based dealing, 21 days and 5 banking days.
  • Close with benefits and risks for buyer and seller when the question asks for evaluation.

Practice questions from Raising of Funds - Non Fund Based

Letter of Credit in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Letter of Credit: frequently asked questions

What is the difference between revolving and standby letters of credit?

A revolving LC reinstates its value for repeated shipments under one arrangement. A standby LC is a backup undertaking that pays only if the applicant defaults. The first is a main payment method and the second is a security.

Who are the parties to a letter of credit?

The applicant (buyer), issuing bank, beneficiary (seller), advising bank, and sometimes a confirming bank and a nominated bank. The issuing bank carries the primary payment undertaking.

What is UCP 600?

It is a set of rules by the International Chamber of Commerce on documentary credits. It governs an LC only if the LC states that it is subject to these rules. It covers matters like irrevocability and examination of documents.

Why is a letter of credit called a non-fund based facility?

The bank gives a commitment rather than lending money upfront. Funds flow only if complying documents are presented and payment is made.