Procurement Glossary
Letter of Credit: Bank guarantee for secure international trade transactions
November 19, 2025
A letter of credit is a bank-guaranteed promise of payment that secures international trade transactions and offers security to both buyers and sellers. This financial instrument plays a central role in global procurement as it minimizes payment risks and creates trust between unknown business partners. Find out below what a letter of credit is, how it works and what significance it has for modern purchasing processes.
Key Facts
- Bank-guaranteed promise of payment for international trade transactions
- Significantly reduces payment default risks for both contracting parties
- Internationally standardized by the Uniform Customs and Practice (UCP 600)
- Enables trade between unknown business partners worldwide
- Typically costs 0.1-2% of the transaction value as a bank fee
Contents
Definition and meaning of Letter of Credit
A letter of credit is a fundamental financial instrument in international trade that structures and secures complex payment transactions.
Basic mode of operation
A letter of credit is a written commitment by a bank to pay a certain amount of money to a beneficiary on behalf of its customer, provided that the agreed documentary requirements are met. The bank acts as a neutral party between the buyer and seller.
- Document-based payment processing without goods inspection
- Independence from the underlying trading relationship
- Binding obligation of the issuing bank
Letter of credit vs. other payment instruments
Compared to prepayment or open invoices, a Letter of Credit offers balanced protection for both parties. While Commercial Invoice payments are only made after receipt of goods, the Letter of Credit guarantees payment upon correct document presentation.
Importance in modern Procurement
For purchasing organizations, a letter of credit enables access to new supplier markets and reduces compliance risks at the same time. It creates trust and planning security, especially for FOB transactions and other international supply conditions.
Process, control and planning
The successful handling of a letter of credit requires structured processes and precise documentation between all parties involved.
Opening process and document creation
The buyer applies to his bank to open a letter of credit with detailed specifications on goods, delivery conditions and required documents. The bank checks the creditworthiness and makes the letter of credit available to the seller via a correspondent bank.
- Credit limit check and provision of collateral
- Precise definition of document requirements
- Determination of validity period and payment modalities
Document verification and payment processing
After the goods have been shipped, the seller submits the required documents such as the bill of lading and packing list to the bank. The bank only checks the conformity of the documents, not the quality of the goods, and initiates payment if the check is positive.
Control and risk management
Purchasing organizations must actively manage letter of credit processes to avoid delays and additional costs. This includes the timely provision of all required documents and the monitoring of deadlines and CIF conditions.
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Operational key figures for letters of credit
The systematic measurement of letter of credit processes enables continuous optimization and cost control in international procurement.
Cost efficiency and fee management
The total costs of a letter of credit include bank fees, processing costs and potential interest on arrears. Typical key figures are the fee ratio in relation to the transaction value and the cost deviation from the original budget planning.
- Letter of credit fees as a percentage of the order value
- Average processing costs per transaction
- Additional costs due to document revisions
Process speed and throughput times
The time from the opening of the letter of credit to the final payment has a significant impact on liquidity planning. Important metrics include the average processing time, the number of document rejections and compliance with agreed payment deadlines.
Quality and compliance rate
The success rate for the first document submission shows the process quality. A high rejection rate indicates a need for improvement in document creation or in the definition of Commercial Invoice requirements.
Delivery and control risks for letters of credit
Despite the inherent security of letters of credit, there are various risks that purchasing organizations must proactively manage.
Document risks and compliance challenges
Discrepancies in documents often lead to payment delays or refusals. Even minor discrepancies between letter of credit terms and submitted documents can require costly rework.
- Inconsistent goods descriptions between documents
- Late submission of documents after the expiry of the validity period
- Incomplete or incorrect shipping documents
Country and banking risks
Political instability or currency crises in exporting countries can jeopardize letter of credit transactions. The creditworthiness of the confirming bank plays a decisive role, as it is ultimately liable for the payment, especially in complex customs clearance processes.
Operational risks in settlement
Communication errors between the parties involved and inadequate internal processes can lead to considerable delays. This results in additional costs and delivery risks, particularly for time-critical deliveries with specific DAP conditions.
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Practical example
A German automotive supplier purchases electronic components worth 500,000 euros from a new supplier in Taiwan. Due to the unknown business relationship, both parties agree on a confirmed letter of credit with a 90-day term. The buyer defines precise document requirements including certificate of origin, test certificate and proof of insurance. After proper delivery of goods and submission of documents, payment is made automatically via the bank, giving both parties security and enabling them to build a long-term business relationship.
- Risk minimization with unknown international suppliers
- Structured document requirements create transparency
- Automated payment processing reduces administrative effort
Current developments and effects
Digitalization and new technologies are fundamentally changing traditional letter of credit processes and creating new opportunities for more efficient processing.
Digital letter of credit platforms
Blockchain-based solutions and electronic document processing reduce processing times from days to hours. Together with technology companies, banks are developing standardized digital platforms that automate manual processes and minimize sources of error.
- Automated document verification through AI systems
- Real-time tracking of transaction status
- Integration into existing ERP systems
Sustainability and ESG compliance
Modern letter of credit structures are increasingly integrating sustainability criteria and ESG requirements. Banks are increasingly demanding proof of environmentally friendly production processes and social standards, which makes export processing more complex.
Effects of AI on document processing
Artificial intelligence is revolutionizing document review for letter of credit transactions. Machine learning algorithms automatically detect discrepancies and significantly speed up approval processes while improving the accuracy of checks.
Conclusion
Letters of credit remain an indispensable instrument for secure international trade transactions, even if digital innovations are revolutionizing processing. For purchasing organizations, they offer optimal protection for new supplier relationships and enable access to global markets. However, their successful use requires precise processes, clear document requirements and continuous risk management. With increasing digitalization, letters of credit are becoming more efficient and cost-effective, but remain relevant in their basic function as a bridge of trust in international trade.
FAQ
What is the difference between a letter of credit and a bank guarantee?
A letter of credit is a promise to pay that automatically leads to payment if the documents are submitted correctly. A bank guarantee, on the other hand, is only activated in the event of breach of contract or non-performance and serves as security for services already rendered.
What are the costs of a letter of credit?
The costs include opening fees (0.1-0.5% of the value), confirmation fees for confirmed letters of credit (0.1-0.3%), processing fees (50-200 euros) and any amendment costs. Additional costs may be incurred for document review and amendments.
How long does it take to process a Letter of Credit?
It typically takes 2-5 working days to open the account and a further 3-7 working days to check the documents. With digital platforms, these times are significantly reduced. The total duration depends on the complexity of the document requirements and the efficiency of all parties involved.
What risks exist despite the letter of credit?
The main risks are document discrepancies that lead to payment delays, country risks in the event of political crises, quality problems with the goods (as only documents are checked) and currency risks in the case of longer terms. Careful contract design minimizes these risks.
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