A Letter of Credit (LC) is a written undertaking by the issuing bank, on behalf of the importer (applicant), to pay the exporter (beneficiary) a specified amount provided the exporter presents complying documents within a stipulated time. LC is the most tested topic in the Trade Finance / Forex section of bank promotion exams — expect 4 to 6 questions at every scale.

Why an LC Is Used — The Core Problem It Solves

International trade involves a fundamental trust gap: the exporter fears non-payment after shipping; the importer fears non-delivery after paying. An LC substitutes the bank’s creditworthiness for the importer’s, giving the exporter certainty of payment if complying documents are presented.

The bank’s obligation is independent of the underlying trade contract — it pays against documents, not goods (UCP 600, Article 5). This is the autonomy principle and is heavily tested.

Parties to a Letter of Credit

Party	Role	Exam Note
Applicant	Importer — requests the issuing bank to open the LC	Also called “opener” or “accountee”
Beneficiary	Exporter — in whose favour LC is opened; presents documents to claim payment	The party that benefits from the LC
Issuing Bank	Importer’s bank — opens the LC, has primary payment obligation	Also called Opening Bank
Advising Bank	Bank in exporter’s country — advises (authenticates) the LC to beneficiary; no payment obligation unless confirmed	Only authenticates; does not undertake to pay
Confirming Bank	Adds its own undertaking to pay — beneficiary now has two banks committed	Used when issuing bank is in a high-risk country
Negotiating Bank	Purchases/discounts the documents from the beneficiary before payment from issuing bank	Takes credit risk on documents
Reimbursing Bank	Authorised by issuing bank to reimburse the negotiating/paying bank	Governed by URR 725 (ICC)

Types of Letter of Credit

1. Based on Payment Timing

Type	When Payment is Made	Risk to Importer
Sight LC (DP)	Immediately on presentation of complying documents — Documents against Payment	Lowest — pays only when docs arrive
Usance / Deferred LC (DA)	On a future date (e.g., 60 / 90 / 180 days after sight or B/L date) — Documents against Acceptance	Importer accepts the bill; pays on due date
Mixed Payment LC	Part on sight, part deferred	Hybrid risk profile

2. Based on Nature / Purpose

Type	Key Feature	Exam Trap
Revocable LC	Can be amended/cancelled without beneficiary’s consent	UCP 600 does NOT recognise revocable LCs — all LCs under UCP 600 are irrevocable
Irrevocable LC	Cannot be amended/cancelled without consent of all parties	Default under UCP 600 — no need to state “irrevocable” in the LC
Confirmed LC	Confirming bank adds its own payment undertaking — double assurance for beneficiary	Only confirming bank can add confirmation, not advising bank automatically
Transferable LC	Beneficiary (first beneficiary) can transfer part/all of LC to second beneficiary (supplier)	Can be transferred only ONCE; second beneficiary cannot transfer further
Back-to-Back LC	Beneficiary uses original LC as security to open a second LC for its supplier	Two separate LCs — not the same as Transferable LC
Red Clause LC	Allows advance payment to beneficiary (pre-shipment finance) before document presentation	“Red clause” historically typed in red ink — pre-shipment advance
Green Clause LC	Extends Red Clause — advance covers storage and warehousing costs also	Red Clause = packing/shipping advance; Green Clause = Red + storage
Revolving LC	Automatically reinstates after each utilisation — used for repeat shipments	Saves cost of opening fresh LC for each shipment
Standby LC (SBLC)	Functions like a Bank Guarantee — invoked only on default, not for routine payments	Governed by ISP98 or UCP 600; more common in US than commercial LCs
Inland LC	Between buyer and seller within India (domestic trade)	Also called ILC; governed by UCP 600 + RBI guidelines

Key UCP 600 Articles — What Exams Test

Article	Subject	Key Rule
Art. 2	Definitions	Defines all parties, complying presentation, honour, negotiate, etc.
Art. 4	Credits vs Contracts	LC is independent of the sale/purchase contract — bank deals in documents, not goods
Art. 5	Documents vs Goods	Banks deal with documents only, NOT with goods/services/performance
Art. 6	Availability, Expiry	LC must state expiry date and place; must state whether available by sight payment, deferred payment, acceptance, or negotiation
Art. 9	Advising Bank	Advising bank only authenticates; it takes no payment undertaking unless it confirms
Art. 14	Document Examination	Nominated bank / issuing bank has maximum 5 banking days to determine if documents comply
Art. 16	Discrepant Documents	If discrepant, bank must give single notice within 5 days — state all discrepancies; cannot add new ones later
Art. 20	Bill of Lading	B/L must appear to be signed by carrier, master, or agent; “on board” notation required
Art. 29	Extension of Expiry	If expiry falls on a non-banking day, extends to first following banking day; shipment date does NOT extend
Art. 31–33	Partial Shipments/Drawings	Permitted unless prohibited; instalment shipments — if one instalment missed, LC ceases for that and subsequent instalments

Documents Required Under an LC

The specific documents are stated in the LC itself. Typical documents in an export LC:

Document	Purpose	Note
Bill of Lading (B/L)	Evidence of shipment and title to goods	Most important document — endorsement transfers title
Commercial Invoice	Details of goods, price, buyer/seller	Must match LC terms exactly
Packing List	Details of packages, weights, marks	Must be consistent with invoice
Certificate of Origin	Country of manufacture — for customs/duty purposes	Issued by Chamber of Commerce or authorised body
Insurance Certificate	Covers goods in transit (CIF terms)	Minimum 110% of CIF value; issued before or on B/L date
Bill of Exchange (Draft)	Instruction to pay — drawn on issuing bank or importer	Required for usance/DA LCs; beneficiary draws the bill
Inspection Certificate	Quality/quantity verification by third party	Required when LC specifies

LC vs Bank Guarantee — Key Differences

Feature	Letter of Credit	Bank Guarantee
Nature	Primary payment instrument — bank pays on presentation of documents	Secondary instrument — bank pays only on default of principal debtor
Invocation	Routine — invoked on every shipment by presenting documents	Invoked only on failure/default — contingent liability
Purpose	Facilitate trade payment	Ensure performance / security
Documents required	Yes — shipping/trade documents	Simple demand / statement of default
Governing rules	UCP 600 / eUCP	URDG 758 (ICC) for demand guarantees
When used	Import/export payment	Bid bond, performance bond, advance payment guarantee

Inland LC (ILC) — RBI Guidelines

An Inland LC operates between a domestic buyer and seller. RBI has issued specific guidelines for ILCs:

• ILC is subject to UCP 600 (unless otherwise stated).
• Usance period for ILC: up to 90 days from date of acceptance.
• Discounting of usance ILC bills: the negotiating/discounting bank takes on the credit risk.
• Banks must ensure ILC is not used for window dressing — circular transactions between related entities are prohibited.
• ILC-based credit facilities are part of the borrower’s working capital limits.

DP vs DA — The Core Exam Distinction

Feature	DP (Documents against Payment)	DA (Documents against Acceptance)
Also called	Sight basis / Cash against documents	Usance basis / Acceptance basis
When importer gets documents	On making immediate payment	On accepting the usance bill of exchange
When payment is made	At sight — on document presentation	On maturity date of accepted bill (30/60/90/180 days)
Credit extended by	No credit — cash payment	Exporter extends credit to importer
Risk to exporter	Lower — documents released only against payment	Higher — documents released against acceptance (promise to pay)
Exam note	Safer for exporter	Provides working capital credit to importer

LC Flow — Step by Step

1. Importer (applicant) requests issuing bank to open LC in favour of exporter.
2. Issuing bank opens LC and sends to advising bank (in exporter’s country) via SWIFT.
3. Advising bank authenticates and advises the LC to the beneficiary (exporter).
4. Exporter ships goods and prepares complying documents.
5. Exporter presents documents to negotiating/advising bank within expiry date.
6. Negotiating bank examines documents — if complying, pays/negotiates the documents.
7. Documents forwarded to issuing bank for reimbursement.
8. Issuing bank examines documents (max 5 banking days) — if complying, reimburses the negotiating bank.
9. Issuing bank releases documents to importer against payment (DP) or acceptance (DA).
10. Importer collects goods using the Bill of Lading.

eUCP — Electronic Letters of Credit

eUCP (Supplement to UCP 600 for Electronic Presentation) allows presentation of electronic records in lieu of paper documents. Version 2.0 was published in 2019 alongside eURC (electronic Uniform Rules for Collections). Key points for exams:

• eUCP does not replace UCP 600 — it supplements it. Where eUCP and UCP 600 conflict, eUCP prevails for electronic credits.
• Electronic record must identify the issuing credit and the beneficiary.
• Corrupted electronic record: presenter notified; has one opportunity to re-present within original presentation period.