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Key takeaways
- Letters of credit help new trading partners build trust by having a bank guarantee payment once the supplier meets agreed-upon conditions.
- Consider getting a letter of credit confirmed—adding a second payment guarantee—if you’re concerned the buyer’s bank may fail to pay as promised or to help mitigate sovereign risk.
- Letters of credit are complex, and errors can delay or disrupt deals. Allow ample time for due diligence and seek guidance from a bank with expertise in international trade.
When you’re expanding into new markets and working with new trading partners, protecting your cash flow is critical. Letters of credit can help you build confidence in your supply chain relationships—and your payments.
“A letter of credit brings a level of trust and comfort into the relationship between a buyer and seller,” said Demet Kologlu, Head of Core Trade Products Sales at J.P. Morgan.
What is a letter of credit?
A letter of credit, also known as a commercial letter of credit, is a bank’s promise to pay a supplier on behalf of a buyer—once the supplier meets specific, agreed-upon conditions.
If a supplier doesn’t want to ship goods before receiving payment and a buyer doesn’t want to pay before receiving goods, a letter of credit gives both parties the confidence to proceed. Letters of credit are typically used for international transactions, where it can be more difficult to evaluate a new trading partner’s reputation and financial standing.
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How letters of credit work in trade
Either the buyer (known as the applicant) or the supplier (known as the beneficiary) can request payment via letter of credit. After the buyer and supplier sign a contract and agree on transacting under a letter of credit, the buyer approaches their bank (the issuing bank) for the letter of credit.
The buyer, supplier and their banks negotiate the letter of credit’s terms. That includes establishing the requirements the supplier must meet before receiving payment, such as documentation proving goods were shipped as ordered.
Letters of credit can be payable as soon as the supplier makes a presentation that complies with the terms and conditions stated under the letter of credit or on a negotiated maturity date. In both cases, the supplier doesn’t have to rely on the buyer’s ability to pay—the issuing bank pays the supplier through the supplier’s bank.
Each party generally bears the fees charged by its own bank. The buyer’s cost for the letter of credit depends on the specific transaction—because the issuing bank is taking on the buyer’s risk, pricing reflects the buyer’s credit standing, the value of the transaction and payment terms.
The supplier’s bank may also charge a fee for processing the payment or confirming it.
Confirmed letters of credit
Confirmed letters of credit give the supplier a second payment guarantee. When a supplier asks to be paid by letter of credit, the risk that the buyer may fail to pay shifts to the issuing bank. If the supplier is also concerned about the issuing bank’s payment or risk associated with the country where the issuing bank is based, the supplier can ask its bank to confirm the letter of credit.
With a confirmed letter of credit, the supplier gets paid by the confirming bank once the supplier makes a presentation that complies with the terms and conditions stated under the letter of credit.
“You can think of it like an insurance policy,” Kologlu said. “It shifts risk to the bank that confirmed the letter of credit.”
Confirmation fees depend on the issuing bank’s country and standing—larger, more established banks in developed economies typically result in lower confirmation fees.
How to use letters of credit effectively
To use letters of credit effectively, keep these considerations in mind:
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If you plan to seek a letter of credit, start early. Letters of credit require negotiations between the buyer, supplier and their banks, as well as due diligence into the buyer’s credit and the supplier’s requirements. The issuing bank is only obligated to pay if the supplier’s documentation presentation matches the letter of credit’s terms precisely—making it critical to get the details right. “We need to review the letter of credit to make sure it’s workable, which means there are no contradictory clauses and it’s possible for the exporter to make a compliant presentation,” Kologlu said. “These instruments are complex, and you need to give your bank lead time to execute them properly.”
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Letters of credit are more complex—and costly—than other payment methods. “Companies typically use them for unknown counterparties or high-risk jurisdictions,” Kologlu said. “As you become more familiar and establish a track record, you may consider switching to other methods of payment, such as an open account, wire transfer or ACH.”
What to look for in an issuing bank
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Trade finance expertise: A bank experienced in international trade can help ensure letters of credit are drafted in a manner that protects both parties’ interests and allow smooth transactions. Banks with trade expertise are also familiar with industry-specific requirements or clauses. “Our dedicated trade team’s experience should bring comfort to buyers and suppliers that letters of credit will be reviewed to meet international rules and all industry standards,” Kologlu said.
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Stability: Letters of credit issued or confirmed by established, well-capitalized banks give suppliers confidence in payment. “Our confirmation is considered gold standard in international trade,” Kologlu said.
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Global reach: When the buyer’s bank already has a relationship with the supplier’s bank, the process is more efficient. The supplier typically dictates which bank will receive payment. “Chances are, J.P. Morgan will be able to meet that requirement from any beneficiary around the globe, either through our branch network or our expansive network of correspondent banks,” Kologlu said.
We’re here to help
Trade finance does more than protect your cash flow—it helps you build trade relationships with confidence. Whether you’re diversifying your supply chain or expanding into new markets, J.P. Morgan bankers and industry specialists provide the guidance to help you get there.
JPMorgan Chase Bank, N.A. Member FDIC. Visit jpmorgan.com/commercial-banking/legal-disclaimer for disclosures and disclaimers related to this content.
