Letter of Credit: what it is and how it can support your international operations?

A letter of credit is one of the most secure payment methods for both buyers and sellers. Learn how it works, the main types available, and how it is used in international trade.

The Letter of Credit as a Security Guarantee in Foreign Trade

If you operate in international trade, whether in finance, treasury or trade departments, you already know that one of the biggest challenges is managing risk in every transaction: ensuring payment, validating shipment and complying with agreed terms.

To mitigate these risks, there are financial instruments designed to provide security to both parties. Among them are letters of credit, also known as documentary credits, which act as a payment mechanism where a financial institution serves as an intermediary and guarantor of the transaction.

Under this structure, the issuing bank commits to pay the exporter provided that all the terms and conditions set out in the credit are met. The importer’s bank will only release payment once it has verified that these requirements have been fulfilled.

Letters of credit are therefore a key tool that transform a commercial agreement into a structured, bank-backed commitment.

How a letter of credit works in practice?

The process begins when the importer instructs its bank to issue a letter of credit in favor of the exporter, guaranteeing payment subject to compliance with predefined conditions. This framework provides assurance to both parties involved in the transaction.

Buyer and seller must first agree on the terms governing the transaction, including:

The exact amount of the transaction.

The latest shipment date.

The deadline for document presentation.

The required documents (commercial invoice, transport document, certificate of origin, insurance, packing list, etc.).

The type of letter of credit (irrevocable, confirmed, payment at sight or deferred, among others).

Once the letter of credit is issued, the exporter ships the goods and submits the required documents to their bank. The bank verifies that the documentation complies strictly with the terms of the credit and identifies any potential discrepancies.

If the documents are compliant, the exporter’s bank forwards them to the issuing bank. Upon verification, the issuing bank undertakes an irrevocable commitment to pay and releases funds to the exporter’s bank according to the agreed terms.

Documentary credit vs. letter of credit: what you should know

In many markets, including Spain, the terms “documentary credit” and “letter of credit” are used interchangeably to describe the same instrument. Both refer to a payment mechanism in which a bank undertakes to pay the exporter against compliant documents.

The distinction is mainly terminological. “Documentary credit” emphasizes the critical role of documentation, as payment depends strictly on compliance with the credit terms. “Letter of credit” is a broader term and more widely used in international contexts. In practice, both operate under the same principles.

Types of letters of credit: choosing the right structure

Depending on your transaction needs, different types of letters of credit can be used:

Irrevocable: The most common type. It cannot be amended or cancelled without the consent of all parties, offering strong security to the beneficiary.

Confirmed: A second bank—usually in the beneficiary’s country—adds its own payment guarantee, enhancing security, particularly in higher-risk markets.

Transferable: Allows the original beneficiary to transfer all or part of the credit to one or more suppliers, supporting complex supply chains.

Standby (SBLC): Functions as a guarantee of payment or performance. It is only activated if the applicant fails to meet contractual obligations.

Revolving: The credit amount is automatically reinstated after use or periodically, making it suitable for ongoing trade relationships.

Sight LC: Payment is made immediately after compliant document verification.

Usance (Deferred) LC: Payment is made at a future date. In this case, the credit may be eligible for financing or discounting.

Selecting the right structure helps streamline operations and reduce friction throughout the process.

Why use a letter of credit in your day-to-day operations?

Incorporating this instrument into your trade operations allows you to:

Reduce the risk of non-payment or non-performance.

Enter new markets or work with new counterparties with greater confidence.

Standardize processes and documentation.

Maintain greater control over each transaction.

Ultimately, it supports more informed decision-making and enhances the security of your international business.

Expert support at every step

Having a financial partner that understands your business is essential. At BBVA, you can access specialized advisory services to help you structure each transaction effectively and select the most suitable solution based on your specific needs.