How a Letter of Credit Works: The 4-Party Mechanism, Step by Step

A letter of credit (LC) works by replacing the buyer’s promise to pay with a bank’s promise to pay — provided the seller presents documents that comply exactly with the LC terms. In India it runs through four parties: the applicant (buyer), the issuing bank, the advising/negotiating bank, and the beneficiary (seller). The issuing bank examines the presented documents and, if they conform, pays — either at sight or on a future date for a usance LC. The whole mechanism is governed internationally by UCP 600, which gives a bank a maximum of five banking days after presentation to examine documents and decide. One thing to fix in your mind from the start: an LC is a payment instrument — it pays against compliant documents — not a default guarantee. That distinction matters, and we’ll come back to it.

This guide walks the four-party flow step by step, explains the document check that decides whether you actually get paid, and clears up sight versus usance. If you’re arranging an LC line as part of a wider banking facility, it sits alongside fund-based limits in your overall corporate finance and debt syndication structure, and pairs naturally with the non-fund-based bank guarantee and letter of credit facilities most importers and contractors need. We run these as ex-banker, CA-led mandates — lender-agnostic across PSU banks, private banks and NBFCs — so the line is sized and priced right and walked through to issuance.

The four parties in a letter of credit

Every documentary credit is a relationship between four roles. Understanding who owes what to whom is the key to understanding the whole instrument.

The issuing bank’s undertaking is the heart of it. Once issued, an LC under UCP 600 is irrevocable by default — it cannot be amended or cancelled without the agreement of the issuing bank, the confirming bank (if any) and the beneficiary. That irrevocability is exactly what lets a seller ship to an unknown buyer in another country: it isn’t trusting the buyer, it’s trusting the buyer’s bank.

How a letter of credit works, step by step

The mechanism follows a predictable sequence. Here is the flow for a typical import LC:

1. Sale contract. Buyer and seller agree terms and that payment will be by letter of credit.
2. LC application. The buyer (applicant) applies to its bank (the issuing bank) for an LC, against a sanctioned LC limit and the agreed margin.
3. Issuance. The issuing bank issues the LC — usually over SWIFT — in favour of the seller (beneficiary), specifying the documents required, the amount, the expiry and the shipment terms.
4. Advising. The LC is routed to a bank in the seller’s country (the advising bank), which authenticates it and passes it to the beneficiary. If the seller wants extra comfort, a confirming bank can add its own undertaking.
5. Shipment. The seller ships the goods and assembles the document set — typically the bill of lading or airway bill, commercial invoice, packing list, insurance certificate and any inspection or origin certificates the LC demands.
6. Presentation. The seller presents the documents to the nominated/negotiating bank within the LC’s presentation period and before expiry.
7. Examination. The bank examines the documents against the LC terms. Under UCP 600 it has a maximum of five banking days following presentation to determine whether the presentation is complying.
8. Payment. If the documents comply, the bank pays — at sight, or at the agreed future date for a usance LC. The issuing bank reimburses, and debits or recovers from the applicant. If documents are discrepant, the bank may refuse, and payment stalls until the discrepancies are waived or corrected.

The critical insight: banks deal in documents, not goods. The issuing bank never inspects the cargo. It pays because the paper conforms. That is why a seemingly trivial discrepancy — a misspelt name, a late shipment, an LC that has expired — can hold up payment even when the goods themselves are perfect.

The document check: where LCs are won or lost

The five-banking-day window in UCP 600 (Article 14) is the operational core of the instrument. The bank checks that the documents, on their face, comply with the credit terms, with each other and with the applicable UCP 600 provisions. There is a standard of strict compliance — documents must match, not merely resemble, what the LC asks for.

Common discrepancies that stall payment:

• Documents presented after the LC’s expiry or outside the presentation period.
• Goods shipped late versus the latest shipment date in the LC.
• Description of goods on the invoice not matching the LC wording.
• Amount drawn exceeding the LC value, or missing a required document.

When a discrepancy is found, the beneficiary’s payment is not automatically lost — but it now depends on the applicant agreeing to waive the discrepancy, which shifts leverage back to the buyer. A clean, first-time-compliant presentation is therefore worth real money. This is the single most under-appreciated part of trade finance, and where preparation pays for itself.

UCP 600 — and how RBI/FEMA override it in India

UCP 600 (ICC Uniform Customs and Practice for Documentary Credits, 2007 revision, ICC Publication No. 600) is the globally adopted rulebook for documentary credits — 39 articles covering issuance, examination, compliance and the obligations of each bank. When an LC states it is subject to UCP 600, those rules govern the credit by contract between the parties.

But UCP 600 is a set of privately adopted rules, not law. In India, where its provisions conflict with the country’s exchange-control and banking regime, RBI directions and FEMA prevail. UCP 600 governs the mechanics of the documentary credit; RBI’s Master Directions and FEMA govern whether and how the underlying cross-border payment, tenor and remittance are permitted. On any conflict, the domestic regulatory framework overrides UCP 600. For an importer, that means an LC structure that is clean under UCP 600 can still fail on a FEMA or RBI point — which is exactly why the file needs banker-grade eyes before issuance.

Sight vs usance letters of credit

The other choice that shapes an LC is when it pays.

A sight LC pays as soon as compliant documents are presented and examined. A usance (or deferred-payment) LC pays at an agreed future date, giving the buyer a credit period — useful when the buyer needs to sell the goods before paying. The seller can frequently discount an accepted usance bill to get cash early, turning the credit period into a financing tool. Which one fits depends on your working-capital cycle and your bargaining position with the counterparty.

LC is a payment instrument — not a guarantee

It bears repeating because the confusion is so common: a letter of credit is a payment instrument that pays on the presentation of compliant documents in the ordinary course of trade. A bank guarantee pays on default — it’s triggered only when the other party fails to perform. An LC is the primary route to payment; a BG is a fallback that you hope is never invoked. They are different tools, governed differently, priced differently, and used at different points in a deal. If you’re weighing the two, our bank guarantee explainer sets out where each belongs.

Where Finnova fits

An LC line is only as good as the way it’s structured, sized and run. We arrange non-fund-based limits — LCs, BGs and SBLCs — alongside the fund-based facilities a business actually needs, lender-agnostic across PSU banks, private banks and NBFCs, and we don’t mass-apply: we close mandates. With ex-banker and CA depth on the file, we get the documentary terms right at issuance, not after the first discrepancy, and walk every facility through to disbursement. Across the firm, that’s ₹4,250 Cr+ mobilised across 100+ corporate-finance mandates since 2011. If an import or domestic LC line is on your agenda, our letter of credit and corporate finance teams structure the limit and negotiate the terms — the right lender, on the right terms, and walked through to disbursement.

Key takeaways

• An LC works through four parties — applicant, issuing bank, advising/negotiating bank, beneficiary — with the issuing bank’s irrevocable promise at its core.
• Banks deal in documents, not goods; payment turns on a complying presentation, not on the cargo itself.
• Under UCP 600, the bank has a maximum of five banking days to examine documents and decide.
• In India, RBI directions and FEMA override UCP 600 where they conflict.
• A sight LC pays on presentation; a usance LC pays at a future date, giving the buyer a credit period.
• An LC is a payment instrument; a bank guarantee pays on default — never equate the two.

FAQ

How does a letter of credit work in simple terms? A buyer’s bank issues a written promise to pay the seller, on the condition that the seller presents documents proving shipment that exactly match the LC’s terms. The seller ships, presents documents to a bank, the bank checks them against the LC, and if they comply the seller is paid — at sight or at a future date. The bank substitutes its creditworthiness for the buyer’s.

What are the four parties to a letter of credit? The applicant (the buyer who requests the LC), the issuing bank (the buyer’s bank that carries the obligation to pay), the advising or negotiating bank (a bank in the seller’s country that authenticates the LC and may pay against documents), and the beneficiary (the seller who ships and gets paid on a compliant presentation).

How long does a bank have to check LC documents? Under UCP 600 Article 14, a bank has a maximum of five banking days following the day of presentation to examine the documents and decide whether the presentation complies. If it finds discrepancies and intends to refuse, it must notify within that window.

What is the difference between a sight LC and a usance LC? A sight LC pays as soon as compliant documents are presented and examined. A usance (deferred-payment) LC pays at an agreed future date — commonly 30, 60 or 90 days after shipment or acceptance — giving the buyer a credit period. The seller can often discount an accepted usance bill for early cash.

Is a letter of credit the same as a bank guarantee? No. A letter of credit is a payment instrument that pays the seller on a complying documentary presentation in the normal course of trade. A bank guarantee pays only on the other party’s default. An LC is the primary route to payment; a BG is a fallback. They are governed and priced differently and used at different points in a transaction.

Does UCP 600 or Indian law govern an LC in India? When an LC states it is subject to UCP 600, those rules govern its mechanics. But UCP 600 is a privately adopted set of rules, not law. In India, where its provisions conflict with RBI directions or FEMA, the domestic exchange-control and banking framework prevails over UCP 600.