A common method of payment that is used in international transactions to facilitate trade by extending credit to banks’ clients. It is a type of letter of credit (L/C) that represents a conditional undertaking which is given by a bank (known as the issuing bank) to another (known as the confirming or advising bank) on behalf of its customer to pay a specified amount of money to a seller (the beneficiary) on presentation of specified documents representing the supply of goods, within specified periods.

The issuing bank, at the request of its customer, opens the letter of credit against a fee. In doing so, it commits itself to honor drawings made against the credit. The beneficiary is normally a provider of goods and/ or services. The documents must conform to terms and conditions specified in the letter of credit and also must be presented at a specified place.

The beneficiary will receive payment as long as he is able to present the documentation specified in the letter of credit. The issuing bank provides a guarantee to the seller upon presentation of required documents. If the documents comply with the terms and conditions set out in the letter of credit, the bank pays the seller the amount due. The advising bank, usually a correspondent bank operating in a foreign country, offers advice to the seller and is responsible for sending the documents to the issuing bank. However, the advising bank is under no obligation towards the beneficiary if the issuing bank doesn’t pay as arranged.

The other type of letter of credit is the standby letter of credit.