Procurement Glossary
Letter of credit business: definition, significance and application in Procurement
November 19, 2025
The letter of credit transaction is an important financing instrument in international trade, which is used in particular for cross-border procurement transactions. It offers both buyers and sellers security when processing transactions with unknown or geographically distant trading partners. Find out below what the letter of credit business is all about, what methods are available and how it is used strategically in Procurement .
Key Facts
- Letters of credit are bank-guaranteed promises of payment for international trade transactions
- They significantly reduce the default risk for both contracting parties
- Documentary letters of credit are the most common form in procurement
- Costs are typically between 0.1% and 2% of the transaction volume
- Processing time is usually 5-10 working days depending on complexity
Contents
Definition: Letter of credit transaction
The letter of credit business comprises all transactions in which a bank enters into an irrevocable payment obligation to a beneficiary on behalf of its customer.
Basic mode of operation
A letter of credit functions as a tripartite legal relationship between the client (buyer), the beneficiary (seller) and the bank issuing the letter of credit. The bank undertakes to make payment as soon as the beneficiary presents the agreed documents.
- Irrevocable payment commitment by the bank
- Document-based processing
- Legal separation from the underlying transaction
Letter of credit business vs. other forms of payment
In contrast to advance payments or outstanding invoices, a letter of credit offers both parties security. While payment terms often involve one-sided risks, the letter of credit creates a balance of interests.
Importance in modern Procurement
For purchasing organizations, the letter of credit business enables the secure development of new supplier markets and supports strategic procurement initiatives in emerging countries. It complements modern e-procurement systems for complex international transactions.
Methods and procedures
The processing of documentary credit transactions follows standardized procedures that vary depending on the type of transaction and risk structure.
Documentary letter of credit procedure
The documentary letter of credit is the standard method in international trade. The supplier receives payment on presentation of specified documents such as commercial invoices, transport documents and certificates of origin.
- Application for a letter of credit by the buyer
- Verification and opening by the bank
- Document submission by the seller
- Document verification and payment
Standby letter of credit process
Standby letters of credit serve as a security instrument and are only utilized if the main obligation is not fulfilled. They are particularly suitable for long-term blanket orders with established suppliers.
Digital processing of letters of credit
Modern platforms enable the electronic processing of letters of credit and significantly shorten processing times. Integration into ERP systems automates workflows and improves transparency for purchasing teams.
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Important KPIs for letter of credit transactions
Measuring the success of letter of credit transactions requires specific key figures that reflect both efficiency and risk management.
Processing efficiency metrics
The average processing time from opening the letter of credit to payment is a key indicator of process quality. Benchmark values are 5-7 working days for standard transactions.
- Credit turnaround time (days)
- First-pass rate for document verification (%)
- Number of discrepancies per letter of credit
Cost efficiency key figures
The letter of credit costs as a percentage of the transaction volume enable benchmarking and negotiations with banks. Typical values range between 0.1% and 0.5% for standard transactions.
Risk and compliance indicators
The success rate of letter of credit payments and the number of legal disputes reflect the quality of purchasing conditions and supplier selection.
Risks, dependencies and countermeasures
Despite the inherent security of letters of credit, there are specific risks that can be minimized by taking appropriate measures.
Document risks and compliance
Discrepancies in letter of credit documents lead to payment delays or refusals. Frequent sources of error are incomplete transport documents or deviating product descriptions.
- Careful formulation of the letter of credit
- Regular supplier training
- Professional document review
Country and banking risks
Political instability or bank defaults can jeopardize letter of credit payments. The selection of renowned correspondent banks and the consideration of country ratings are essential for master data management.
Cost risks and budget planning
Letter of credit fees can vary considerably for complex transactions. Unforeseen changes or extensions cause additional costs that must be taken into account in the ordering policy.
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Practical example
A German automotive supplier purchases critical electronic components from a new supplier in Taiwan. Due to the unknown nature of the partner and the high transaction volume of 2 million euros, an irrevocable documentary letter of credit is agreed. The supplier receives payment security, while the buyer ensures that the goods are delivered according to specification by checking the documents. The letter of credit costs of 0.3% are more than compensated for by the risk minimization and improved negotiating position.
- Reduction of the default risk to almost zero
- Improved cash flow planning for both parties
- Building a trusting business relationship
Current developments and effects
The letter of credit business is currently going through a phase of digitalization and standardization, which is opening up new opportunities for efficient procurement processes.
Blockchain-based letters of credit
Distributed ledger technologies are revolutionizing the processing of letters of credit by increasing transparency and reducing processing times. Pilot projects show time savings of up to 80% compared to traditional processes.
- Automated smart contracts
- Real-time monitoring of transactions
- Reduced documentation errors
AI-supported document verification
Artificial intelligence optimizes the verification of letter of credit documents and automatically identifies discrepancies. This speeds up processing and reduces manual sources of error in invoice verification.
Sustainability letters of credit
Green Trade Finance integrates ESG criteria into letter of credit structures and supports sustainable procurement strategies. Banks offer interest rate advantages for environmentally certified suppliers and thus promote responsible spending analyses.
Conclusion
The letter of credit business remains an indispensable instrument for secure international procurement, especially for new suppliers or in politically unstable regions. Advancing digitalization through blockchain and AI technologies will further increase efficiency and transparency. Purchasing organizations should use letters of credit strategically to minimize risks and open up new markets. Careful consideration of costs and benefits as well as integration into modern procurement processes are crucial for success.
FAQ
What is the difference between a letter of credit and a bank guarantee?
A letter of credit is a promise to pay against presentation of documents, whereas a bank guarantee is only used if the main obligation is not fulfilled. Letters of credit are primary payment instruments, guarantees are secondary securities.
How long does it take to process a letter of credit?
It typically takes 2-3 working days to open a letter of credit and a further 3-5 working days to check the documents. For complex transactions or discrepancies, processing can take up to 14 days.
What are the costs of letter of credit transactions?
Letter of credit fees are made up of opening fees, ongoing commissions and processing fees. The total costs are usually between 0.1% and 2% of the transaction volume, depending on the term, complexity and bank relationship.
Can letters of credit be changed retrospectively?
Amendments to letters of credit are possible, but require the consent of all parties involved. Each amendment incurs additional fees and can delay processing. Therefore, letter of credit terms should be precisely formulated from the outset.
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