Understanding Letters of Credit: Definition, Types, and Usage

When a new supplier says cash first, goods later, the deal and maybe even your heart are put on pause. All that groundwork is suddenly held hostage by a trust problem no one asked for.

A letter of credit is the emotional and financial balm that saves the day here. Bank-approved assurances that money will flow, without you having to pay upfront. This blog covers what LCs are, how they work, and alternatives if they're not your cup of tea.

What is a letter of credit?

A letter of credit (LC) from the bank is a document that assures your supplier they'll be paid. Its whole job is to shift the risk from the supplier to the bank.

Shipments shouldn't stall because two new companies played chicken with who pays first. That's the letter of credit meaning in banking, in practice: "If you don't trust me yet, trust my bank."

Who shows up to this arrangement:

• Applicant: That's you, the buyer, asking your bank to issue the LC in the first place.
• Beneficiary: The supplier who'll get paid once they've proven they shipped the goods.
• Issuing bank: Your bank, the one putting its name behind your promise to pay.
• Advising bank: Usually the supplier's bank, which receives the LC and confirms it's genuine.

What the bank promises: No matter what happens to your business, it'll pay the supplier on your behalf once they meet the agreed conditions.

How does the letter of credit work?

A letter of credit sounds complicated until you see it broken down. It's really just a relay race with paperwork instead of a baton.

Here's what happens between agreeing to a deal and actually getting paid.

Step 1: Buyer and supplier agree on terms

Before any bank gets involved, commercials get settled. That means price, quantity, volume, and delivery timelines. Payment terms aren't in the picture yet.

Step 2: Buyer applies for the LC

With money on their mind, the buyer will visit their bank to vouch for the deal or supply agreement. They need to apply for an LC favoring the supplier.

Watch out for the different types of letters of credit. The documents required shift slightly depending on which one you pick.

Step 3: Issuing bank sends the LC to the advising bank

Once it's approved, the buyer's bank sends the letter of credit to the named advising bank. This step is the bank's formal promise taking shape.

In the UAE, this usually takes a couple of working days once the application clears internal approval, though the credit checks before that can take longer.

Step 4: Advising bank verifies and notifies the supplier

Once the tests come back clean, the advising bank passes it to the supplier. This step exists to catch fraud before goods change hands.

Given that it blocks capital and delays can still creep in, production usually starts after the LC is confirmed. So, plan your shipment timeline with some room to spare.

Step 5: Supplier ships and submits documents

The supplier ships the goods, then hands their bank the paperwork. That's usually the invoice, bill of lading, and packing list.

Which exact documents are asked for depends on the INCOTERMS agreed upfront.

Step 6: Both banks check the documents

The advising bank checks the paperwork, then sends it on for a second check. Every detail is verified against the LC's exact wording.

A mismatch here, even a typo, can delay or block payment entirely.

Step 7: Issuing bank releases payment

If everything checks out, the issuing bank pays the advising bank, who pays the supplier. By the time money moves, the goods are usually already at sea.

How soon payment lands depends on which type of LC you've signed. All this manual checking is exactly why banks and businesses are leaning on trade finance automation to cut down the back-and-forth.

Which type of letter of credit do you actually need?

An LC defines payment conditions, liabilities, and actions in case of failures. Different LC types change specific terms of that arrangement.

Here are the types of letters of credit and when you'd need them.

Sight LC

A sight LC is all about immediate payment. As soon as the goods are shipped and the relevant documents are vetted, the bank will settle the invoice. This works well for long lead-time transportation and long-term supplies of high-value goods where waiting until delivery isn't practical.

Usance LC

A supplier agrees to a usance LC when they need a guarantee more than expedited payment. With this LC, the bank pays your supplier after an agreed period, such as 30, 60, or 90 days. Choosing a usance LC also gives you time to receive, use, or sell the goods before payment.

Confirmed LC

A confirmed LC means a second bank also promises to pay your supplier. This gives them extra protection if your bank can't pay. While confirmed LCs are rare, they're a viable option when your bank or country isn't considered very stable.

Transferable LC

As the name implies, your supplier can transfer this LC to another beneficiary, usually their supplier. You create the LC to assure your supplier of payment, and they pass that assurance on to their supplier. It works best when you're an intermediary buying traded goods from one supplier and selling them to your customer.

Standby LC

A standby LC is a backup payment or performance commitment. The bank pays when the supplier makes a valid claim under the standby. This is usually when you (the buyer) don’t meet your end of the deal.

LC types can also be combined, depending on the transaction. For example, a letter of credit can be confirmed and transferable while also being payable at sight or on usance terms.

Two ancient LC types based on flexibility

• Irrevocable LCs: They cannot be changed without the required parties' agreement and are the standard today.
• Revocable LCs: These can be changed or cancelled without the beneficiary's consent and are rarely used now.

What does a letter of credit cost in the UAE?

Letters of credit come with multiple bank charges, including issuance, amendment, confirmation, and advisement. With so many line items at play, the final number is a moving target.

Financial institutions like ADCB often charge 0.125% per month on the first AED 100,000. Most banks also set minimum charges and billing periods for LCs. For budgeting, that’s a good range to start planning.

Different charges to account for:

• Issuance fee: The bank’s charge for opening and maintaining the LC.
• Amendment fee: Covers changes such as extending the LC or increasing its value.
• Confirmation fee: Charged when another bank adds its own payment commitment.
• Negotiation fee: Covers checking and processing documents presented for payment.
• Discrepancy charges: May apply when presented documents don't meet the LC terms.
• Cancellation fee: May apply when an LC is cancelled before it expires.

The biggest drivers are the LC amount, validity period, bank, and risk level. Before opening an LC, it's best to check the bank's minimum charges and third-party fees.

Pro tip: An LC protects the payment, not the exchange rate. Budgeting for FX risk is the best way to account for currency swings.

What documents will the bank ask for when issuing an LC?

LC applications can mean paperwork from purchase orders to invoices, shipping details, and KYC records. Keep a live checklist because missing even one document can delay issuance.

The exact list varies by bank and deal, but it usually covers the buyer, seller, goods, value, and shipment. Here are the core documents to keep ready:

• LC application: The bank’s form captures the LC amount, currency, expiry, payment terms, and other instructions needed to issue it.
• Sales contract or purchase order: Shows what you agreed to buy, from whom, and on what commercial terms.
• Proforma or commercial invoice: Sets out the goods, quantity, price, and total value so the bank can match the LC to the transaction.
• Beneficiary details: Provides the supplier’s legal name, address, and bank details so the LC identifies the correct recipient.
• Shipping details: Covers the transport method, shipment dates, ports, and whether partial shipments or transshipment are allowed.
• Required trade documents: Lists what the seller must present for payment, such as a bill of lading, certificate of origin, or packing list.
• Insurance documents: Proves the required cargo cover is in place when insurance forms part of the transaction terms.
• KYC and financial documents: Clarifies the company’s identity and financial standing needed to assess the customer and transaction.
• Collateral or margin details: Shows the cash margin or other security the bank requires before issuing the LC, where applicable.

Keep the checklist aligned with the LC terms, because mismatched or missing documents can hold up issuance or payment. It also saves a headache later during account reconciliation, when everything needs to match on paper.

Pro tip: Ask the bank for its final document list before applying, especially when the shipment involves multiple parties or countries.

Where do letters of credit go wrong in banking and supplies?

An LC comes with a lot of fine print. Keeping every clause and detail right to the letter is a huge ask. Here are a few ways it usually goes wrong.

Incorrect or missing documents

The seller submits documents that are missing, incomplete, or don't match the LC terms. This can happen with invoices, bills of lading, certificates, or packing lists.

The bank can raise a discrepancy and delay or refuse payment until it is resolved. Avoid this by checking every document against the LC before submission.

Shipment details don't match

Dates, ports, quantities, or shipping methods can differ from what the LC specifies. These errors often happen when shipment arrangements change after the LC is issued.

A mismatch can trigger a discrepancy even when the goods themselves are correct. Since most payment confirmations rely on paperwork, not physical checks, keep a document checklist and confirm any changes with the bank before shipment.

LC terms are unclear or unrealistic

The LC may require documents the seller cannot reasonably provide, or set shipment and presentation deadlines that are too tight. These issues are easier to catch before the LC is issued.

Changing terms later can mean amendment fees, delays, or supplier disputes. So, review the LC with the supplier before issuance and make requirements practical.

Documents are submitted late

Even accurate documents can cause problems if they're presented after the LC's deadlines. Delays can happen because of shipping changes, missing paperwork, or internal handoffs.

Late presentation can put payment at risk. Track shipment and document deadlines together, and give the seller enough time to prepare and submit everything.

What are the alternatives to a letter of credit?

Sure, an LC offers strong payment protection, but for smaller or lower-risk transactions, it can bring more friction than value. Especially with cross-border business payments, where the strict paperwork, bank fees, and documentary requirements may not be worth it.

Options that put payment first

These alternatives move money earlier in the transaction, without requiring a bank to guarantee payment. They work best when the buyer trusts the supplier and has solid legal and supply chain agreements in place.

• Advance payment: The buyer pays before goods are shipped or services are delivered. Handy for high-value investments or when the supplier needs funds upfront.
• Direct transfer: The buyer sends funds straight to the seller's bank account. A good fit for routine payments that don't need extra bank-backed controls.

Buyers can sometimes negotiate better pricing in exchange for paying earlier.

Tools to reduce risk

You don't always need an LC to give the supplier payment assurance. These options bring the bank in where it matters, with less paperwork and cost.

• Bank guarantee: The bank promises to pay if the buyer fails to meet a specified obligation. Useful for protection against default or non-performance.
• Documentary collection: Banks handle trade documents and release them against payment or acceptance. This gives you more control than open account terms without the full machinery of an LC.

Solutions that simplify trade

For established supplier relationships or repeat business, simpler tools can keep trade moving. They are easier to manage and often cheaper, but offer less payment protection.

• Open account: The seller ships first, and the buyer pays later under agreed credit terms. Best suited to established relationships where the seller is comfortable extending credit.

If you're on the receiving end, the same trust issue becomes a trade receivables headache. The sweet spot is balancing payment certainty, risk protection, and simplicity. Alaan Superpay brings these together with corporate cards, spend controls, and accounting automation across payables and accounts receivable.

Get the payment setup that lifts smart and heavy

An LC offers strong protection and assurances for everyone. But it isn't the answer for every transaction and can have pretty strict rules. The right setup balances payment certainty, risk protection, and simplicity.

Depending on the deal, supplier relationship, and control, you need a tweaked mix of protection, flexibility, and visibility. Alaan brings this together with Supercard and its spend management platform. That includes vendor onboarding, AI-native spend controls, and workflows that integrate with your accounts.

Ready to make business payments simpler? Book a demo with Alaan and find a setup that works for your business.

FAQs

How does a letter of credit work?

A buyer applies through their bank, which sends the LC to the supplier's bank. The supplier ships the goods and submits matching documents. Once everything checks out, the bank releases payment to the supplier.

What are the types of letters of credit?

The main two are sight, which pays right away, and usance, which pays later. Others like confirmed, transferable, and standby add extra protection depending on the deal. Most UAE businesses just default to a sight LC that's irrevocable.

Is a letter of credit or a bank guarantee better?

They solve different problems, so neither is automatically better. A letter of credit is the actual payment method for a shipment. A bank guarantee only pays out if someone fails to deliver on their promise.

How long does a letter of credit take to arrange?

In the UAE, issuing the LC itself usually takes a couple of working days once approved. The slower part is everything before that, like credit checks and paperwork. Leave extra time, especially for a first-time supplier.

What is a letter of credit used for?

It guarantees payment on international trade deals, especially between parties who haven't built trust yet. It shows up most in importing and exporting, where goods and money cross borders together. It takes the guesswork out of getting paid.