Trade Finance and Letters of Credit: A Guide for International Business

International trade presents a fundamental problem: buyer and seller often do not know each other, operate under different legal systems, may be separated by significant time zones, and must somehow manage the risk that the buyer will not pay after the goods are shipped, or conversely that the seller will not ship after payment is made. Trade finance instruments exist to resolve precisely this dilemma — shifting credit risk from parties who cannot assess each other to banks who can.

This guide explains the main instruments available, how a letter of credit works step by step, what documentary discrepancies are and why they matter, and how to navigate the UK trade finance market whether you are an established exporter or a business entering international trade for the first time.

The Trade Finance Spectrum

Trade finance instruments range in complexity from simple open account trading (buyer and seller trust each other; no bank involvement beyond payment execution) to fully secured documentary credit arrangements. Between these poles:

Open account: the seller ships goods and invoices the buyer; the buyer pays in agreed terms (30, 60, 90 days). Default risk sits entirely with the seller. Appropriate for established relationships and stable jurisdictions but exposes the exporter to significant risk in new markets.

Documentary collection: a middle ground. The seller ships goods but instructs their bank to release the shipping documents (which control ownership of the goods) only on payment or acceptance of a draft by the buyer. Less secure than an LC but cheaper; documents travel through the banking system but the banks do not guarantee payment.

Letter of Credit (Documentary Credit): the most secure instrument for international trade. The buyer's bank (the issuing bank) guarantees payment to the seller on presentation of conforming documents. The seller's credit risk is the bank's creditworthiness, not the buyer's.

Bank Guarantee and Standby LC: contingency instruments; the bank commits to pay if the counterparty defaults on an underlying obligation. Used for performance bonds, tender bonds, and advance payment guarantees.

Supply Chain Finance / Invoice Finance: the seller's invoices are financed by a third party (a bank or specialist); the seller receives early payment; the buyer pays on its extended terms to the financier. Improves cash flow for the seller without changing the buyer's payment schedule.

What a Letter of Credit Is and How It Works

A Letter of Credit (LC, also called a Documentary Credit) is an irrevocable undertaking by the issuing bank to pay the beneficiary (the seller) a specified amount, provided the beneficiary presents documents that strictly comply with the LC terms within the validity period.

The LC structure involves four parties:

1. The applicant (buyer): applies to their bank for the LC; the bank is taking a credit risk on the buyer's ability to reimburse it
2. The issuing bank (buyer's bank): issues the LC; takes credit risk on the buyer; provides the guarantee that underpins the transaction
3. The advising bank (seller's bank): receives the LC from the issuing bank and advises it to the seller; at minimum, confirms the LC is genuine; may also add its own confirmation (see below)
4. The beneficiary (seller): the party in whose favour the LC is issued; ships the goods and presents documents to receive payment

The process in outline:

1. Buyer and seller agree commercial terms and specify that payment will be by LC
2. Buyer applies to issuing bank to open an LC, specifying all required terms: documents required, port of loading, latest shipment date, LC expiry date, currency and amount
3. Issuing bank opens the LC and transmits it to the advising bank via SWIFT (MT700 message)
4. Advising bank authenticates the LC and advises it to the seller; if the seller requests confirmation, the advising bank may add its own guarantee (a Confirmed LC)
5. Seller manufactures/procures goods and arranges shipment; obtains all required documents
6. Seller presents documents to the advising/nominated bank before the LC expiry date
7. Bank examines documents for compliance with LC terms; if compliant, payment is released
8. If documents are discrepant, the bank notifies the seller; seller may request buyer to waive discrepancies, or correct documents if possible

Types of Letter of Credit

Irrevocable LC: standard; cannot be amended or cancelled without the agreement of all parties including the beneficiary. All modern LCs under UCP 600 (the international rules published by the International Chamber of Commerce) are irrevocable by default.

Confirmed LC: in addition to the issuing bank's undertaking, a second bank (typically in the seller's country) adds its own confirmation — a separate, independent payment undertaking. Eliminates the seller's exposure to country risk on the issuing bank's jurisdiction. Appropriate when the issuing bank is in a country with transfer restrictions, sanctions risk, or institutional weakness.

Standby LC: functions more like a bank guarantee than a traditional documentary credit. Payment under a standby LC is a contingency — it is called only if the applicant fails to perform an underlying obligation. Widely used in the US market as an alternative to demand guarantees.

Revolving LC: automatically reinstates to the original amount after each utilisation, up to a specified total or number of utilisations. Efficient for ongoing regular shipments between the same parties.

Transferable LC: the beneficiary can transfer all or part of the LC to a secondary beneficiary — typically the actual manufacturer or supplier. Allows middlemen to use the LC as security with their own suppliers without involving the ultimate buyer directly.

Red Clause and Green Clause LCs: contain provisions allowing the advising bank to make advance payments to the beneficiary against the LC before documents are presented. Used in certain agricultural and commodity markets where sellers need pre-shipment financing.

SWIFT LC Messages

Banks communicate LC instructions through standardised SWIFT message types:

• MT700: Issue of a Documentary Credit — the primary message by which the issuing bank advises the LC to the advising bank
• MT707: Amendment to a Documentary Credit — any change to the original LC terms
• MT720: Transfer of a Documentary Credit
• MT754: Advice of Payment/Acceptance/Negotiation — confirms that documents have been presented and are being honoured or negotiated

For business clients monitoring LC transactions, these message types are the reference points when tracking the status of a transaction with your bank or trade finance specialist.

Documentary Discrepancies: The Biggest Source of Delay

Studies by the International Chamber of Commerce have consistently found that approximately 60–70% of first presentations under LCs contain discrepancies — documents that do not strictly comply with the LC terms. This is a remarkably high failure rate and understanding why it happens is critical for businesses that use LCs regularly.

Common discrepancies include:

• Date discrepancies: shipment date on the bill of lading is after the latest shipment date specified in the LC
• Description of goods: the invoice description of goods does not exactly match the LC description (even minor wording differences matter)
• Port names: bill of lading shows a different port of loading or discharge than specified in the LC
• Quantity or amount: slight over- or under-shipment or an amount exceeding LC tolerance limits
• Stale documents: documents presented after the LC expiry or after the specified presentation period following shipment
• Missing or incomplete documents: a required document not presented, or a required endorsement absent

When documents are discrepant, the bank issues a notice of refusal. The beneficiary's options are: request the buyer to waive the discrepancies (the issuing bank may accept this if the buyer agrees); correct the documents where possible and re-present before expiry; accept that payment will be delayed while discrepancies are resolved.

Discrepancies are expensive in time and sometimes in cost (examination fees are charged on each presentation). Careful preparation of documents — reviewing the LC terms meticulously before shipment, ensuring all requirements are satisfiable — is the only reliable solution.

A commercially experienced trade finance lawyer or trade finance specialist reviewing the LC terms before the seller commits to them can identify and negotiate out impractical or impossible conditions before the transaction begins.

Costs: What to Budget

LC costs accumulate across the transaction:

Issuing bank charges (typically borne by the buyer):

• Issuance commission: 0.15–0.5% per quarter of LC amount (minimum typically £100–500)
• Amendment fee: £50–200 per amendment
• SWIFT transmission fee: £20–50

Advising bank charges (typically borne by the buyer or shared):

• Advising fee: £50–200
• Confirmation fee (if confirmed): 0.1–0.3% per quarter additional
• Examination/negotiation fee: 0.1–0.2% of face value

Total cost for a standard LC for a 90-day transaction: On a £100,000 LC, total bank charges across both parties might be £500–1,500. For high-risk jurisdictions or long-term LCs, costs are higher.

Documentation costs: preparation of trade documents, particularly certificates of origin, insurance certificates, and inspection certificates, involves additional third-party costs. For complex transactions, a freight forwarder who is experienced with LC requirements is invaluable.

UK Trade Finance Providers

Major clearing banks: Barclays, HSBC, Lloyds, and NatWest all have trade finance teams; Barclays and HSBC are particularly active given their historical international networks. Standard for established businesses with existing banking relationships.

Specialist trade finance for SMEs: Bibby Financial Services, Close Brothers Trade Finance, and similar specialist lenders serve businesses that are too small for priority attention from clearing banks or whose risk profile requires more flexible underwriting.

Export finance: UK Export Finance (UKEF) — the government's export credit agency — provides guarantees, insurance, and direct lending to support UK exporters in challenging markets. UKEF can issue guarantees that enable UK banks to issue LCs to buyers in markets where the bank would otherwise decline. For businesses entering difficult markets for the first time, UKEF's products deserve consideration.

When to Use an LC vs Simpler Alternatives

An LC is the right tool when: you are entering a new market with an unknown buyer; the transaction value is significant; the buyer's country has foreign exchange controls or transfer risk; your bank offers competitive LC rates; and the documentation requirement is manageable for the nature of the goods.

An LC may be unnecessary when: you have an established relationship with the buyer; the buyer is in a low-risk jurisdiction with freely convertible currency; the value is modest; or the documentary requirements would be impractical for the type of goods (services, for instance, are poorly suited to documentary credit).

Trade finance instruments are subject to the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce, which governs the rights and obligations of all parties. This guide provides general information only. Specific transaction terms, jurisdiction risk, and credit considerations require professional advice from a qualified trade finance specialist. Rules and bank charges change; always verify current costs with your bank before committing to LC terms.

How Global Investments Can Help

International property transactions, business acquisitions, and cross-border investments sometimes involve trade finance structures — particularly where development finance, construction contracts, or supply of materials to international projects is involved. Global Investments can connect internationally active business clients with appropriate trade finance specialists and banking institutions, and can advise on the banking and corporate structures best suited to businesses operating internationally.

Contact our team to discuss your trade finance requirements.