What letter of credit means
A letter of credit replaces trust between two businesses with the promise of a bank.
An importer in Lagos and a supplier in Guangzhou have never met. The supplier does not want to ship before payment. The importer does not want to pay before shipment. A letter of credit resolves the standoff.
The importer's bank issues a credit in favour of the supplier, undertaking to pay a stated amount on presentation of specified documents by a stated date. The supplier ships, presents the documents, and is paid. The importer's bank then debits the importer.
The defining feature is that banks deal in documents, not in goods. The bank does not inspect the cargo, verify quality or care whether the goods are what the importer expected. If the documents comply with the credit on their face, the bank pays.
That is what makes the instrument reliable for the seller and risky for the buyer who did not specify the right documents.
How it is used
The sequence is fixed and each step matters.
The parties agree the sale, including that payment will be by letter of credit, and agree which documents will be required.
The importer applies to its bank, which issues the credit in favour of the supplier, usually advised through a bank in the supplier's country.
The supplier checks the credit carefully. If it requires a document the supplier cannot produce, or a shipment date it cannot meet, that must be amended before shipping, not afterwards.
The supplier ships and presents the documents: commercial invoice, bill of lading, packing list, insurance certificate and any inspection or origin certificates the credit requires.
The bank examines the documents against the credit. If they comply, it pays. If there is a discrepancy, however small, it may refuse, and payment then depends on the importer waiving the discrepancy.
Discrepancies are common, and they are the main practical risk for a seller.
Key features
- A bank undertaking to pay against compliant documents
- Independent of the underlying sale contract
- Banks examine documents, not goods
- Strict compliance is required; small discrepancies can defeat presentation
- Can be confirmed by a second bank to add its own undertaking
- Governed by internationally recognised banking practice rules
How this works in Nigeria
Letters of credit sit inside the wider Nigerian import documentation chain.
Before anything ships, the importer opens a Form M through an authorised dealer bank, which registers the transaction and links it to the foreign exchange arrangements. The credit is issued through the same bank. On arrival, the Pre Arrival Assessment Report and Customs clearance follow, against the bill of lading and the other documents.
Foreign exchange availability is the practical constraint. A bank issuing a credit is committing to pay in foreign currency, and access to it has varied considerably over recent years. Importers should confirm with their bank what the funding arrangement actually is before committing to a supplier, rather than assuming the credit will be issued because the application was accepted.
Confirmation is the other point Nigerian exporters should understand. A Nigerian supplier receiving a credit from an unfamiliar foreign bank can ask for it to be confirmed by a bank it does trust, which then adds its own undertaking to pay. It costs more and it removes the risk of the issuing bank or its country.
And the documentation discipline that governs demurrage applies here too. Names, descriptions and quantities must match across the credit, the invoice and the bill of lading, because the bank compares them literally.
Letter of credit vs bank guarantee vs advance payment
Three ways of bridging trust in a trade transaction.
A letter of credit is a payment mechanism. The bank pays the seller against compliant documents in the ordinary course of the transaction. It is designed to be used.
A bank guarantee or a performance bond is a security mechanism. The bank pays only if something goes wrong, such as the contractor failing to perform. It is designed not to be used.
Advance payment is the simplest and the riskiest for the buyer. Money goes first and the buyer relies entirely on the seller shipping. It suits small orders and established relationships.
For a first transaction with an unfamiliar overseas supplier, a letter of credit is the balanced answer: the seller ships knowing payment is assured, and the buyer pays knowing shipment happened and the documents exist.
Limits and risks
The credit is independent of the sale contract, so a bank will pay against compliant documents even where the goods are defective or were never really shipped as described. Fraud is the narrow exception, and it is difficult to establish quickly.
Strict compliance also works against sellers. A misspelled name, a date outside the shipment window or a missing certificate can defeat a presentation, and the seller then depends on the buyer waiving the discrepancy.
Costs are real. Issuance, advising, confirmation, amendment and discrepancy fees add up, which makes the instrument disproportionate for small orders.
And it is slower than a transfer. The documentary cycle adds time at both ends, which matters where goods are needed quickly.
Worth knowing
Specify exactly which documents the credit requires, and check the credit against what your supplier can actually produce before they ship. Nigerian importers create their own discrepancies by requiring certificates the supplier cannot obtain, and then have to waive them anyway after paying amendment fees.
Questions people ask
What is a letter of credit?
A bank undertaking to pay a seller a stated amount on presentation of specified documents within a stated period. It allows two businesses that do not know each other to trade across borders.
Do banks check the goods?
No. Banks deal in documents, not goods. If the documents comply with the credit on their face, the bank pays, regardless of whether the cargo is what the buyer expected.
What is a discrepancy?
Any way in which the presented documents fail to comply strictly with the credit, including misspellings, dates outside the shipment window and missing certificates. The bank may refuse payment, and the seller then depends on the buyer waiving it.
What is a confirmed letter of credit?
One where a second bank, usually in the seller's country, adds its own undertaking to pay. It costs more and removes the risk of the issuing bank and its country, which matters when dealing with unfamiliar counterparties.
How does a letter of credit fit with Form M?
The Form M is opened through an authorised dealer bank before shipment and registers the import transaction. The credit is normally issued through the same bank, and the documents must match across both.
When should I use a letter of credit?
For a first or high value transaction with an overseas counterparty you do not know. For small orders the fees make it disproportionate, and for established relationships a transfer is usually simpler.