Letter of Credit: Payment Instrument or Bank Guarantee?

A letter of credit can help secure international trade, but the protection it provides depends on the type of undertaking issued by the bank. For a Credit Manager, the essential question is whether the bank is expected to pay for the transaction or step in if the buyer fails to pay.

Terminology matters: In international banking, a commercial letter of credit is generally another name for a documentary credit. A standby letter of credit (SBLC), however, is generally used as a bank-backed security instrument. The expression letter of credit on its own is therefore ambiguous.

Two different functions: payment and security

When negotiating an export sale, the seller may want a bank to assume a payment obligation. Two commonly used structures answer different needs:

Commercial or documentary letter of credit: the issuing bank undertakes to honour a complying documentary presentation. Bank payment is part of the agreed settlement process.
Standby letter of credit: the buyer normally pays under the commercial contract. The beneficiary calls on the standby if the specified event occurs, commonly the buyer's failure to pay, and presents the documents required by its terms.

Both may create independent bank undertakings. Neither should be assessed solely by its name: the wording, governing rules, expiry, available amount and required documents determine how it works.

Commercial letter of credit: the bank pays against documents

Under a commercial letter of credit, the importer requests issuance of a credit in favour of the exporter. The issuing bank commits to honour a presentation that complies with the credit's terms and applicable rules, usually the UCP 600 of the International Chamber of Commerce.

An advising bank may authenticate and advise the credit to the exporter. A confirming bank may add its own independent undertaking. An advising bank is not automatically a confirming bank, and its involvement does not, by itself, transfer the issuing bank's credit risk.

Original diagram illustrating the opening stages of a commercial letter of credit — Original diagram: opening of a commercial letter of credit. This illustration concerns the payment mechanism, not a standby guarantee.

Once the goods are shipped or the service is performed, the exporter presents the stipulated documents to the designated bank. The bank examines the documents, rather than independently verifying the physical goods or contractual performance. A discrepancy may prevent payment unless appropriately resolved.

Original diagram illustrating documentary presentation and settlement under a commercial letter of credit — Original diagram: documentary presentation and payment under a commercial letter of credit.

For a full explanation of the process, see The Documentary Credit.

Standby letter of credit: a bank guarantee in economic substance

A standby letter of credit (SBLC) generally serves as security rather than the normal payment method. The seller invoices the buyer under the commercial contract. If the buyer fails to pay and the conditions specified in the standby are met, the seller may present a demand to the issuing bank.

The buyer arranges for a bank to issue a standby in favour of the seller.
The seller supplies goods or services and invoices the buyer under the agreed terms.
The buyer normally settles the invoice directly.
If a covered default occurs, the seller makes a demand supported by the documents required by the standby.
The bank examines that presentation and honours it if it complies with the standby's terms and applicable rules.

Standbys are commonly issued subject to ISP98 (ICC Publication 590), although some are subject to UCP 600. A demand guarantee subject to URDG 758 is a related but distinct instrument. The governing rules and wording must be checked rather than assumed.

Important: a standby is not an unconditional promise to reimburse any unpaid invoice. Payment may depend on the exact wording of the demand, supporting declarations, deadlines, place of presentation and other documentary conditions. A standby is also not identical to a French-law suretyship (cautionnement).

Read the dedicated tutorial: The Standby Letter of Credit.

Commercial letter of credit vs standby letter of credit

Criterion	Commercial letter of credit	Standby letter of credit
Primary purpose	Payment for a transaction	Security against a specified default
Normal settlement	Bank honours complying documents	Buyer pays directly
Bank is called upon	In the ordinary course of settlement	Usually following a specified failure
Typical documents	Commercial and transport documents stipulated by the credit	Demand and default statement or other documents stipulated by the standby
Common rules	UCP 600	ISP98; sometimes UCP 600
Key risk for seller	Documentary discrepancies and bank/country risk	Non-compliant demand, expiry and bank/country risk

Neither instrument is inherently better. A commercial credit may be appropriate for a one-off shipment with documentary control; a standby may better suit recurring deliveries on open-account terms, where normal payment remains the buyer's responsibility.

What should the Credit Manager check?

Identity and standing of the issuing bank: assess its creditworthiness and the relevant country and transfer risks.
Confirmation: determine whether an acceptable bank should add its independent undertaking, and assess the cost.
Amount and duration: ensure coverage matches the maximum outstanding exposure, including the relevant shipment and payment periods.
Demand conditions: confirm that every required document can realistically be produced without depending on the defaulting buyer's cooperation.
Expiry and presentation: allow enough time for late payment to become identifiable and for a compliant demand to be submitted.
Applicable rules: identify UCP 600, ISP98 or other rules expressly incorporated in the instrument.

Credit management principle: the purpose is not to accumulate banking instruments, but to select a protection that matches the actual commercial exposure and can be enforced when needed.