Letter of Credit: Process, Costs, and Documentary Collection

With a new supplier relationship in the Far East, one question comes up early: who bears the risk when payment and shipment don't happen in the same place at the same time? A letter of credit answers exactly that question by tying payment to the presentation of precisely specified documents, independent of how much trust exists between the parties.

In brief: A letter of credit (Akkreditiv) is a payment promise from the buyer's bank to the supplier, honoured only once exactly agreed documents, such as the invoice, shipping papers, and certificate of origin, are presented. It follows a globally uniform rulebook (UCP 600 from the International Chamber of Commerce) and secures both sides, but costs more than the simpler documentary collection, where the bank only exchanges documents without guaranteeing payment.

What is a letter of credit?

A letter of credit, also referred to in banking as a documentary credit, is an independent payment undertaking from a bank, valid regardless of the underlying sales contract. The buyer's bank commits to the supplier that it will pay the agreed amount once the supplier presents the documents specified in the credit, on time and in the exact form required.

This independence from the underlying deal is the key point: the bank only checks whether the submitted documents match the credit's terms, not whether the goods were actually delivered in the agreed quality. According to IHK Pfalz, it's exactly this strict document-matching principle that makes it one of the most effective security instruments in foreign trade.

In our sourcing projects, we typically use a letter of credit for the first two to three orders with a new supplier. Once the relationship runs smoothly, most of our clients switch to simpler, cheaper terms such as partial prepayment or an open payment term.

How does a letter of credit work?

The process follows a fixed, internationally standardised pattern governed by the ICC's UCP 600 rules:

• Contract signed with a letter-of-credit clause. Buyer and supplier agree in the sales contract to pay via this instrument, and specify exactly which documents must be presented.

• Opening by the buyer's bank. The buyer instructs their bank (the issuing bank) to open the credit in the supplier's favour.

• Advising to the supplier's bank. The issuing bank forwards the credit to the supplier's bank, which advises or confirms it to the supplier.

• Shipment and document submission. The supplier ships the goods and submits the required documents, such as the invoice, bill of lading, and certificate of origin, to their bank.

• Document review and payment. The banks check the documents against the credit's terms. If they match, payment is released or committed for the agreed date.

If the documents deviate from the credit's terms even in a minor, formal way, banks call this a discrepancy, which blocks payment until it's resolved or the buyer explicitly accepts it.

What types of letter of credit are there?

These types, also called documentary credits in banking terminology, mainly differ by how many banks secure the payment and exactly when payment happens, much like payment terms also vary depending on the agreed Incoterms. The table below maps out the most common variants:

For most first-time deals with new suppliers in the Far East, the irrevocable, confirmed sight letter of credit is the standard choice, since it gives both sides the greatest possible security.

Letter of credit vs. documentary collection: what's the difference?

Documentary collection is the simpler, cheaper alternative, where the bank merely exchanges documents against payment or acceptance without issuing its own payment guarantee. If the buyer refuses to pay, the supplier is left holding goods already shipped.

Commerzbank accordingly describes it as the instrument offering the highest security in documentary payment transactions, while documentary collection is geared mainly toward well-established business relationships.

Who ends up paying the letter of credit's costs?

This instrument incurs fees at opening, potentially at confirmation by a second bank, and for document review. How these costs are split between buyer and supplier is fundamentally a matter of negotiation and should be settled in the sales contract upfront.

According to IHK Düsseldorf, banks often base the opening commission on a staggered scale that decreases percentage-wise as the goods value rises. Smaller orders also tend to run into a bank's minimum fee, which is why it pays off economically mainly from a certain minimum order value upward.

In practice, a simple rule of thumb has worked well for us: each side covers its own bank's fees. The buyer pays the issuing bank's opening fee, the supplier pays the advising or confirming bank's fees. If this isn't clarified in advance, it regularly leads to disputes at final settlement, especially once a second bank's confirmation is added into the mix.

When does a letter of credit pay off?

It pays off above all when there's no solid trust basis between the parties yet, or when the supplier's country risk is assessed as elevated, for instance when importing from the Far East from a new supplier. For established supplier relationships with a multi-year track record, the extra cost and administrative effort often outweigh the benefit gained.

The value of the goods matters too: for smaller test orders, arranging this kind of cover is often disproportionate to the amount being secured, while it pays for itself quickly on larger first orders.

What mistakes commonly happen with a letter of credit?

Most problems here don't come from the instrument itself, but from imprecise wording and insufficient coordination beforehand. The following points are easy to avoid:

• Document requirements set too late. Which documents must be presented, and in what form, needs to be settled in the sales contract, not after the credit is opened.

• Deadlines cut too tight. If there isn't enough time between shipment and the expiry date to gather the documents, unnecessary discrepancies result.

• Cost split not agreed. Without a clear contractual rule, opening and confirmation fees regularly cause disputes.

• Small deviations underestimated. Even a misspelled product name triggers a discrepancy under strict document review.

• Skipping confirmation when it was needed. If the issuing bank's country risk is elevated, a second bank should add its own payment guarantee.

Clearing up these points before the contract is signed avoids the delays that otherwise only surface during document review.

How does a letter of credit fit into the rest of the import process?

It is closely tied to the rest of the trade documents, since those exact documents are what release payment, especially where several manufacturing sites and supply-chain stages come together.

A practical example: when an importer orders components from a new supplier in the Far East and secures payment through a letter of credit, the real import process already begins before the goods are even shipped. The documents specified in the credit, such as the invoice, bill of lading, and certificate of origin, have to match the later customs papers exactly. If the product description on the invoice deviates even slightly from the wording agreed in the sales contract, that creates not just a discrepancy in the credit review, but usually a delay at customs clearance too, since both checks build on the same documents.

So payment doesn't stall on a miscalculated duty, the customs value of the shipment should also be calculated early, in parallel with arranging the credit itself. Treating the letter of credit, trade documents, and customs value as one connected system from the start, rather than as separate tasks, cuts the risk of an otherwise secured payment getting held up by an uncoordinated customs formality.

Frequently Asked Questions

What is a letter of credit? A payment promise from the buyer's bank to the supplier, honoured once exactly specified documents are presented on time.

How does a letter of credit work? Contract signed with a letter-of-credit clause, opening by the buyer's bank, advising to the supplier's bank, shipment with document submission, review, and payment.

What types of letter of credit are there? Among others: irrevocable, confirmed, sight, and deferred (usance) letters of credit, plus transferable ones, depending on how many banks secure it and when payment happens.

What's the difference between a letter of credit and documentary collection? With a letter of credit, the bank guarantees payment; with documentary collection, it only exchanges documents against payment or acceptance, without being liable itself.

Who pays the costs of a letter of credit? Common practice, but negotiable: each side covers its own bank's fees, unless the sales contract states otherwise.

Conclusion: A letter of credit as a substitute for trust in international trade

A letter of credit replaces missing trust between new business partners with a bank-verified payment guarantee tied to exactly specified documents. Clarifying document requirements early and settling the cost split contractually gets you that security without burdening the supplier relationship with unnecessary discrepancies.

As process specialists, we help our clients decide whether, and in what form, this kind of payment security makes sense for a new supplier relationship, and align payment terms with the entire procurement process. 👉 Schedule a free consultation and we'll work out together which payment security fits your next order.