Letter of Credit (LC) in Textile Trade: Process, Documentation and Role in International Business

International trade has become the backbone of the modern global economy. Every day, businesses buy and sell goods across national borders, connecting manufacturers, suppliers, wholesalers, and consumers worldwide. However, conducting business internationally presents unique challenges. Unlike domestic transactions, buyers and sellers in different countries often have limited knowledge of each other's financial strength, business reputation, legal environment, and commercial practices. As a result, both parties face significant risks.

An exporter may worry about whether the importer will make payment after receiving the goods. Similarly, an importer may be concerned about whether the exporter will ship the correct goods in the required quality and quantity. To address these concerns and establish trust between trading partners, financial institutions have developed various trade finance instruments. Among these instruments, the Letter of Credit (LC) is one of the most widely used and trusted mechanisms.

A Letter of Credit serves as a secure payment method in international trade by involving banks as intermediaries. Through this arrangement, banks provide assurance that payment will be made to the exporter provided that the exporter fulfills the conditions specified in the credit. As a result, the LC system significantly reduces commercial risks and promotes confidence in cross-border transactions.

This article provides a comprehensive discussion of the meaning, importance, parties involved, types, components, operational procedures, governing rules, advantages, limitations, and import procedures associated with Letters of Credit.

Meaning of Letter of Credit

A Letter of Credit (LC) is a written undertaking issued by a bank on behalf of an importer, known as the applicant, promising to make payment to an exporter, known as the beneficiary, provided that the exporter presents documents that strictly comply with the terms and conditions specified in the credit.

In simple terms, a Letter of Credit is a bank's conditional guarantee of payment. The issuing bank agrees to pay the exporter if the exporter fulfills all documentary requirements stated in the LC.

The LC mechanism shifts a significant portion of payment risk from the buyer to the bank. Instead of relying solely on the buyer's promise to pay, the exporter relies on the creditworthiness and commitment of the issuing bank. This feature makes Letters of Credit particularly useful in international transactions involving large values, unfamiliar business partners, or politically and economically unstable markets.

Importance of Letter of Credit in International Trade

Letter of Credit plays a crucial role in international trade by:

• Reducing payment risk for exporters
• Providing assurance of shipment compliance for importers
• Facilitating financing from banks
• Ensuring documentary control rather than physical goods control

LCs act as a bridge of trust between buyers and sellers who may have no prior business relationship.

Parties Involved in a Letter of Credit

Several parties participate in an LC transaction, each having distinct roles and responsibilities.

Applicant

The applicant is the importer or buyer who requests the issuing bank to open a Letter of Credit in favor of the exporter. The applicant remains ultimately responsible for reimbursing the bank for payments made under the LC.

Issuing Bank

The issuing bank is the importer's bank that establishes the LC and undertakes to honor payment when compliant documents are presented. It assumes the primary obligation under the credit.

Beneficiary

The beneficiary is the exporter or seller in whose favor the Letter of Credit is issued. The beneficiary becomes entitled to payment upon meeting the documentary requirements.

Advising Bank

The advising bank is generally located in the exporter's country. Its function is to verify the authenticity of the LC and advise it to the beneficiary.

Confirming Bank

A confirming bank adds its own independent guarantee of payment to the LC at the request of the issuing bank. This additional assurance protects the exporter against country risk and issuing bank risk.

Negotiating Bank

The negotiating bank reviews submitted documents and may purchase or negotiate the export documents if they comply with the LC terms.

Reimbursing Bank

The reimbursing bank acts on behalf of the issuing bank and provides reimbursement to the negotiating bank for payments made under the credit.

Types of Letter of Credit

Letters of Credit can be structured in different ways depending on the nature of the transaction, the level of risk involved, and the financing requirements of the parties. Understanding the various types of LC is essential for importers, exporters, bankers, and trade finance professionals because each type offers different levels of security, flexibility, and payment arrangements.

1. Revocable Letter of Credit

A Revocable Letter of Credit is a credit that can be amended, modified, or canceled by the issuing bank at any time without prior notice to the beneficiary.

Under this type of LC, the issuing bank retains the right to alter the terms of the credit without obtaining the consent of the exporter. Because the beneficiary does not have a guaranteed commitment from the bank, this form of credit provides very limited protection to the exporter.

Features

• Can be modified or canceled at any time.
• Consent of the beneficiary is not required.
• Provides minimal security to the exporter.
• Rarely used in modern international trade.

Advantages

• Greater flexibility for the importer.
• Easy amendment process.

Disadvantages

• High risk for exporters.
• Lack of payment security.
• Generally unacceptable to international sellers.

Practical Example

An importer opens a revocable LC for purchasing machinery from a foreign supplier. Before shipment takes place, market conditions change and the importer requests cancellation. The issuing bank may cancel the LC without obtaining approval from the exporter.

Because of the uncertainty associated with revocable credits, international banking practice today overwhelmingly favors irrevocable credits.

2. Irrevocable Letter of Credit

An Irrevocable Letter of Credit cannot be amended, modified, or canceled without the consent of all parties involved, namely the applicant, beneficiary, issuing bank, and any confirming bank.

This is the most commonly used type of LC in international trade because it provides a legally binding payment commitment from the issuing bank.

Features

• Cannot be canceled unilaterally.
• Provides stronger protection to the exporter.
• Creates a definite obligation on the issuing bank.
• Governed by UCP 600 unless otherwise stated.

Advantages

• High degree of payment security.
• Encourages international trade relationships.
• Provides certainty to both parties.

Disadvantages

• Less flexibility once issued.
• Amendments may require considerable time and cost.

Practical Example

A Bangladeshi garment manufacturer exports apparel to a European buyer under an irrevocable LC. Once the LC is issued, the seller can proceed with production knowing the payment commitment cannot be withdrawn without consent.

Because of its reliability and international acceptance, the irrevocable LC has become the standard form used in global commerce.

3. Confirmed Letter of Credit

A Confirmed Letter of Credit is an irrevocable LC to which another bank, known as the confirming bank, adds its own independent guarantee of payment.

The confirming bank undertakes to honor payment even if the issuing bank fails to do so due to insolvency, political instability, foreign exchange restrictions, or other reasons.

Features

• Includes two guarantees:
  • Issuing bank guarantee.
  • Confirming bank guarantee.
• Reduces country and bank risk.
• Frequently used in high-risk markets.

Advantages

• Maximum protection for exporters.
• Eliminates concerns regarding issuing bank reliability.
• Reduces political and sovereign risk.

Disadvantages

• Additional confirmation charges.
• More expensive than ordinary LCs.

Practical Example

An exporter in Bangladesh receives an LC issued by a bank located in a politically unstable country. To reduce risk, a reputable international bank confirms the LC, ensuring payment even if the issuing bank cannot fulfill its obligation.

This type of credit is particularly valuable when exporters deal with unfamiliar countries or weaker banking systems.

4. Unconfirmed Letter of Credit

An Unconfirmed Letter of Credit is an LC that carries only the undertaking of the issuing bank. No additional guarantee from another bank is provided.

This is the standard form when the exporter has confidence in the issuing bank and the political and economic environment of the importing country.

Features

• Only the issuing bank is obligated to pay.
• Lower banking costs.
• Common in low-risk international markets.

Advantages

• Less expensive.
• Simpler structure.
• Faster processing.

Disadvantages

• Exporter bears country and bank risk.
• No additional payment security.

Practical Example

A manufacturer exports products to a long-term customer in Germany under an LC issued by a highly rated international bank. Since risk is low, no confirmation is required.

5. Sight Letter of Credit

A Sight Letter of Credit requires payment to be made immediately upon presentation and acceptance of complying documents.

The exporter receives payment "at sight," meaning as soon as the bank determines that all documents comply with LC requirements.

Features

• Immediate payment after document examination.
• Improves exporter cash flow.
• Most common for short-term trade transactions.

Advantages

• Quick access to funds.
• Reduced financing requirements.
• Lower credit exposure for exporter.

Disadvantages

• Immediate cash outflow for importer.
• Less flexibility in payment timing.

Practical Example

A textile exporter ships fabric under a sight LC and submits the required documents. After verification, the negotiating bank releases payment immediately.

6. Usance or Deferred Payment Letter of Credit

A Usance LC, also called a Deferred Payment LC, allows payment at a future specified date rather than immediately after document presentation.

Common payment periods include:

• 30 days
• 60 days
• 90 days
• 120 days
• 180 days

Features

• Provides credit to the importer.
• Payment occurs after a predetermined period.
• Documents are usually released before final payment.

Advantages

For Importers

• Better cash flow management.
• Additional time to sell goods.
• Reduced working capital pressure.

For Exporters

• Potential access to discounting or financing.
• Increased competitiveness.

Disadvantages

• Delayed payment.
• Increased financing costs.

Practical Example

An importer purchases industrial equipment under a 90-day usance LC. The exporter submits compliant documents and receives payment after ninety days or earlier through bank discounting arrangements.

7. Transferable Letter of Credit

A Transferable Letter of Credit allows the first beneficiary to transfer all or part of the credit to one or more second beneficiaries.

This type of LC is widely used by intermediaries, traders, and buying agents who source products from manufacturers.

Features

• Transfer permitted only if expressly stated.
• May be transferred once.
• Facilitates intermediary trade.

Advantages

• Eliminates need for intermediaries to provide separate financing.
• Simplifies supply chain transactions.
• Supports international trading operations.

Disadvantages

• Complex documentation.
• Limited flexibility in subsequent transfers.

Practical Example

A trading company receives an LC from an overseas buyer and transfers part of the credit to local manufacturers supplying the products.

The trader earns a margin while suppliers receive payment assurance through the transferred LC.

8. Back-to-Back Letter of Credit

A Back-to-Back Letter of Credit is issued against the security of an existing master LC.

Instead of transferring the original LC, the beneficiary uses it as collateral to open another LC in favor of the supplier.

Features

• Based on an original export LC.
• Commonly used by garment exporters and trading houses.
• Facilitates procurement of raw materials.

Advantages

• Enables financing without additional collateral.
• Supports intermediary trading.
• Assists export-oriented industries.

Disadvantages

• More complex banking procedures.
• Additional bank charges.
• Multiple compliance requirements.

Practical Example

A garment exporter receives an export LC worth USD 1 million from a foreign buyer. Using that LC as security, the exporter opens back-to-back LCs to purchase fabric, accessories, and packaging materials from suppliers.

This type of LC is extensively used in the ready-made garment sector.

9. Standby Letter of Credit (SBLC)

A Standby Letter of Credit functions more like a bank guarantee than a traditional trade payment instrument.

The bank pays only if the applicant fails to fulfill contractual or payment obligations.

Features

• Secondary payment mechanism.
• Used as a financial guarantee.
• Common in construction and service contracts.

Advantages

• Strong protection for beneficiaries.
• Enhances contractual confidence.
• Broad commercial applications.

Disadvantages

• Additional costs.
• Detailed documentation requirements.

Practical Example

A contractor working on an international infrastructure project provides a standby LC to guarantee performance. If contractual obligations are not fulfilled, the beneficiary may claim payment under the SBLC.

10. Revolving Letter of Credit

A Revolving Letter of Credit automatically reinstates its value after utilization, eliminating the need to issue multiple LCs for recurring transactions.

Features

• Suitable for regular shipments.
• Automatically renews within specified limits.
• Reduces administrative work.

Advantages

• Saves time and cost.
• Ideal for long-term supply arrangements.
• Streamlines trade operations.

Disadvantages

• Requires careful monitoring.
• Potential exposure if limits are not controlled effectively.

Practical Example

A retailer imports products every month from the same supplier. Instead of opening twelve separate LCs annually, a revolving LC automatically restores the available credit following each shipment.

Comparative Summary of Major LC Types

Key Components of a Letter of Credit

Amount and Currency

The LC specifies the amount payable and the currency in which payment will be made.

Description of Goods

Goods must be described clearly and consistently with the sales contract.

Shipment Terms

Includes shipment date, port of loading, port of discharge, mode of transport and partial shipment conditions.

Required Documents

Typical documents include:

• Commercial Invoice
• Bill of Lading or Air Waybill
• Insurance Certificate
• Certificate of Origin
• Inspection Certificate

Validity and Expiry

The LC specifies expiry date and place for presentation of documents.

Process of Letter of Credit Operation

Opening of Letter of Credit

The importer applies to the issuing bank to open an LC by submitting:

• LC application form
• Sales contract or proforma invoice
• Margin and required securities

Advising of Letter of Credit

The issuing bank transmits the LC to the advising bank, which then advises it to the beneficiary after authentication.

Shipment of Goods

After receiving and checking the LC, the exporter ships the goods according to LC terms.

Presentation of Documents

The exporter submits documents to the negotiating or advising bank within the stipulated time.

Examination of Documents

Banks examine documents strictly on the basis of:

• LC terms
• UCP 600
• International Standard Banking Practice (ISBP)

Payment or Acceptance

If documents comply:

• Payment is made at sight or
• Acceptance is given for future payment

Reimbursement and Settlement

The negotiating bank is reimbursed by the issuing or reimbursing bank and the importer receives documents for goods clearance.

UCP 600 and Letter of Credit

Uniform Customs and Practice for Documentary Credits

UCP 600, issued by the International Chamber of Commerce (ICC), governs the operation of Letters of Credit worldwide. It defines:

• Roles and responsibilities of banks
• Standard interpretation of LC terms
• Rules for examination of documents

Principle of Documentary Compliance

Banks deal with documents, not goods. Even if goods are defective, payment cannot be refused if documents comply.

Discrepancies in Letter of Credit Documents

Common Causes of Discrepancies

Typical discrepancies include:

• Late shipment
• Late presentation
• Description mismatch
• Incorrect documents
• Unauthorized issuance

Consequences of Discrepancies

Discrepant documents may result in:

• Payment refusal
• Delayed settlement
• Additional charges
• Loss of exporter credibility

Advantages of Letter of Credit

Benefits for Exporters

• Assured payment
• Reduced credit risk
• Access to bank financing
• International credibility

Benefits for Importers

• Control over shipment terms
• Assurance of document compliance
• Improved supplier confidence

Limitations of Letter of Credit

Despite its advantages, LC has some limitations:

• Costly bank charges
• Rigid compliance requirements
• Time‑consuming documentation
• No guarantee of goods quality

Procedure for Import Through Letter of Credit (LC)

The import process through a Letter of Credit follows a structured sequence of activities designed to ensure financial security, regulatory compliance, and proper control of foreign exchange transactions.

Step 1: Sales Contract and Requirement of LC

The process begins when the importer and exporter enter into a sales agreement or issue a proforma invoice specifying product details, price, quantity, delivery terms, shipment schedule, and method of payment. If payment is agreed through an LC, the importer proceeds with the application process.

Step 2: Application for Opening Letter of Credit

The importer submits:

• LC Application Form
• Proforma Invoice
• Sales Contract
• Import Licenses (if applicable)
• Margin Deposits
• Security Documents

The bank evaluates the financial standing and creditworthiness of the importer before approving the application.

Step 3: Issuance of Letter of Credit

Following approval, the issuing bank creates the LC according to the applicant's instructions and transmits it electronically through the SWIFT network to the advising bank.

Step 4: Advising of Letter of Credit

The advising bank authenticates the LC and forwards it to the exporter. The exporter carefully checks all terms and conditions before proceeding with production or shipment.

Step 5: Shipment of Goods

Upon acceptance of LC terms, the exporter manufactures or procures the goods and ships them within the validity period specified in the LC.

Step 6: Preparation and Presentation of Documents

The exporter prepares all required export documents and submits them to the negotiating bank.

These commonly include:

• Commercial Invoice
• Bill of Exchange
• Bill of Lading
• Air Waybill
• Insurance Certificate
• Certificate of Origin
• Packing List
• Inspection Certificate

Step 7: Scrutiny and Negotiation of Documents

The negotiating bank conducts a detailed examination of the submitted documents.

• If documents comply, the bank negotiates or forwards them for payment.
• If discrepancies are detected, corrections may be requested or documents may be forwarded for acceptance subject to waiver.

Step 8: Receipt of Import Bills by Issuing Bank

The issuing bank receives and records the documents, verifies compliance independently, and communicates any discrepancies to the importer.

Step 9: Lodgment of Import Documents

When documents are found compliant or accepted by the importer, the issuing bank settles the payment obligation and transfers the transaction amount to the appropriate accounting records, including the Payment Against Documents (PAD) account where applicable.

Step 10: Intimation to Importer

The bank formally notifies the importer about:

• Bill Value
• Applicable Interest
• Foreign Exchange Conversion Amount
• Banking Charges
• Retirement Requirements

Step 11: Retirement of Import Documents

The importer pays the required amount, including charges and interest. After settlement, the bank releases the shipping documents needed to clear goods from customs.

Step 12: Submission of Bill of Entry

Following customs clearance, the importer submits the authenticated Bill of Entry to the issuing bank within the prescribed regulatory timeframe.

Step 13: Matching and Closure of Import Transaction

The bank verifies the Bill of Entry against:

• IMP Form
• Invoice
• LC Details
• Customs Documentation

If everything is satisfactory, the import file is closed. If irregularities exist, the matter may be referred to the relevant regulatory authority for further action.

Conclusion

The Letter of Credit remains one of the most reliable and widely accepted instruments in international trade finance. By providing a bank-backed commitment of payment, it effectively bridges the trust gap between importers and exporters operating across different countries, legal systems, and business environments. Through standardized procedures governed by UCP 600, Letters of Credit create a secure framework that protects both trading parties while facilitating the smooth flow of global commerce.

Although the LC process involves extensive documentation, strict compliance requirements, and banking charges, its benefits often outweigh these challenges, particularly in high-value transactions and new business relationships. Exporters gain assurance of payment, while importers receive confidence that shipment conditions must be fulfilled before payment is released. Consequently, a thorough understanding of LC operations, documentary requirements, banking procedures, and regulatory compliance is essential for successful participation in international trade. Proper LC management not only minimizes disputes and delays but also contributes to stronger commercial relationships and more efficient global business operations.