Glossary term
Letter of Credit
A bank’s undertaking to pay a seller against documents that comply exactly with the credit’s terms.
An undertaking by a bank, at the buyer’s request, to pay the seller on presentation of documents that comply with the credit. It substitutes a bank’s creditworthiness for the buyer’s, which is what makes trade between strangers possible.
The principle that governs it is that banks deal in documents, not goods. Payment follows a compliant presentation regardless of whether the goods are satisfactory, and is refused on a discrepancy regardless of whether the goods are perfect. A large share of first presentations are discrepant, usually over details that have nothing to do with the shipment.
The practical discipline is to read the credit when it arrives, not when documents are being assembled: anything that cannot be complied with must be amended before shipping. Also called a documentary credit.