What is a letter of credit?

• A. Financial guarantee issued by a bank on behalf of a buyer to ensure that a seller receives payment as long as all terms of a contract are met
• B. A document that confirms shipment terms
• C. A contract between buyer and seller
• D. An insurance policy for cargo

Answer: (A)

A letter of credit is a bank’s commitment to pay the seller on behalf of the buyer, provided the seller presents the specified documents showing that the contract terms have been met. This arrangement gives the seller a reliable guarantee of payment even if the buyer later defaults, while giving the buyer confidence that payment will occur only when the agreed conditions and documentation are satisfied. The bank’s obligation is typically independent of the actual dispute between buyer and seller, so long as the documents comply with the letter of credit terms.

Commonly required documents include a commercial invoice, a clean bill of lading, and any inspection or certificate documents specified in the credit. This instrument differs from simply confirming shipment terms, a separate contract between buyer and seller, or cargo insurance. A letter of credit acts as payment assurance in international trade, and is often irrevocable and may be confirmed or standby to enhance security.