Letter of credit

A letter of credit is a bank's promise to pay a seller once shipping documents proving a cargo was loaded and meets contract terms are presented, reducing payment risk.

International commodity cargoes often move between parties who have no prior relationship and limited ability to chase payment across borders if something goes wrong. A letter of credit solves this by putting a bank in the middle: the buyer’s bank promises to pay the seller once the seller presents documents proving the cargo was shipped and meets the contract’s terms, typically a bill of lading and inspection certificates.

This shifts payment risk from the seller trusting the buyer to the seller trusting the buyer’s bank, which is normally a far more reliable counterparty. Letters of credit are especially common in trades priced under FOB or CIF terms, where the physical handover of the cargo and the transfer of payment need to be coordinated precisely despite happening in different countries under different legal systems.