Letter of Credit: Definition, Types and Role in Commodity Trade
Definition
A letter of credit (LC) is a written undertaking issued by a bank (the issuing bank) on behalf of a buyer, guaranteeing payment to a seller upon presentation of documents that comply with the terms and conditions specified in the credit. In commodity trading, letters of credit are the primary payment mechanism for international physical transactions, providing security to both buyer and seller across jurisdictions and counterparty risk profiles.
How a Letter of Credit Works
The LC mechanism operates through a structured sequence:
- The buyer and seller agree on commercial terms for a commodity sale
- The buyer applies to their bank (issuing bank) for an LC
- The issuing bank issues the LC, specifying required documents, amount, and expiry date
- The LC is sent to the seller, typically through an advising bank in the seller’s country
- The seller ships the commodity and assembles the required documents
- Documents are presented to the nominated bank for examination
- If documents comply with LC terms, payment is made to the seller
- The issuing bank debits the buyer’s account and releases documents for cargo collection
The critical principle is that banks deal in documents, not goods. The bank’s obligation to pay depends solely on documentary compliance, not on the condition or existence of the underlying commodity.
Types of Letters of Credit
| Type | Description | Common Use |
|---|---|---|
| Irrevocable LC | Cannot be amended or cancelled without all parties’ consent | Standard in commodity trade |
| Confirmed LC | A second bank (confirming bank) adds its own payment guarantee | When issuing bank credit risk is a concern |
| Sight LC | Payment made immediately upon compliant document presentation | Spot commodity purchases |
| Usance (Deferred Payment) LC | Payment made at a future date (30, 60, 90, 180 days) | When buyer needs time to on-sell |
| Transferable LC | Beneficiary can transfer LC rights to a second beneficiary | Intermediary traders |
| Standby LC | Serves as a guarantee of payment; drawn only if primary payment fails | Backup security |
| Revolving LC | Automatically reinstates after each drawing, up to a maximum | Ongoing supply arrangements |
Key Documents
Common documents required under commodity trade LCs:
- Bill of Lading: Proof of shipment and document of title
- Commercial Invoice: Commodity description, price, and terms
- Certificate of Origin: Country where the commodity was produced
- Inspection Certificate: Independent verification of quality and quantity
- Insurance Certificate: Evidence of cargo insurance coverage
- Weight Certificate: Verified commodity weight
For detailed treatment of documentary credit practice, see our guide to documentary credit in commodity trade.
Governing Rules: UCP 600
Letters of credit are governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), published by the International Chamber of Commerce (ICC). UCP 600 provides standardised rules accepted by banks and traders worldwide, covering:
- Independence of the credit from the underlying contract
- Bank obligations and responsibilities
- Document examination standards (strict compliance)
- Time limits for document examination (five banking days maximum)
- Transfer and assignment provisions
Role in Commodity Trading
LCs serve multiple functions in commodity trading:
Payment Security: Sellers are assured of payment if documents comply, regardless of the buyer’s willingness or ability to pay from their own resources.
Credit Enhancement: An LC substitutes the creditworthiness of the issuing bank for that of the buyer — critical when trading with counterparties in weaker jurisdictions.
Financing Vehicle: LCs facilitate access to trade finance. Deferred payment LCs provide working capital by allowing buyers to take delivery before payment is due. Sellers can discount (sell for early payment) compliant documents.
Compliance Tool: LC documentation requirements ensure commodities are properly shipped, insured, inspected, and documented — supporting AML compliance and sanctions screening.
Costs
LC costs typically include:
- Issuance fee: 0.1–1.5 per cent of LC value (charged by issuing bank)
- Confirmation fee: 0.5–3 per cent per annum (for confirmed LCs, charged by confirming bank)
- Advising fee: Fixed fee (charged by advising bank)
- Amendment fee: Fixed fee per amendment
- Discrepancy fee: Fixed fee per set of discrepant documents
These costs are factored into commodity trade economics as part of the overall structured commodity finance calculation.
Swiss Market Context
Switzerland’s commodity trading hub — particularly Geneva — processes a significant volume of commodity LCs annually. Swiss banks act as issuing banks, confirming banks, advising banks, and negotiating banks, leveraging deep commodity expertise to process complex documentary credit transactions efficiently. This banking infrastructure is a key competitive advantage for Switzerland’s commodity hub position.
Key Takeaways
- Letters of credit are the standard payment mechanism in international commodity trade
- They provide payment security by substituting bank credit for buyer credit
- UCP 600 provides the internationally accepted governing framework
- LCs serve simultaneously as payment instruments, financing tools, and compliance mechanisms
- Swiss banks possess deep LC expertise specific to commodity trading sectors
Donovan Vanderbilt is a contributing editor at ZUG COMMODITIES, covering trade finance, commodity markets, and Swiss banking. Based in Zurich, he draws on two decades of experience in commodity market analysis and institutional research.