star-1
star-2

Letter of Credit

Definition

A letter of credit is a financial instrument issued by a bank at the request of a buyer on behalf of a seller, guaranteeing the seller will receive payment as long as the terms and conditions of the letter are met.

It provides security to both parties in international trade by reducing payment risk and ensuring compliance with contractual obligations.

In the AML/CFT context, letters of credit can present elevated risks related to trade-based money laundering, sanction evasion, and fraudulent trade practices.

Because these instruments facilitate cross-border trade and high-value flows, they require scrutiny to ensure the legitimacy of goods, parties, and transactional flows.

Explanation

Letters of credit (LCs) play a pivotal role in international commerce by linking three parties: the buyer (applicant), the seller (beneficiary), and the issuing bank (issuer).

The bank undertakes to pay the seller’s presentation of documents that comply strictly with the LC terms.

This instrument is especially important when buyers and sellers operate in unfamiliar jurisdictions or where credit risk is high.

From a compliance perspective, an LC requires thorough due diligence on the counterparties and the underlying trade transaction.

Because trade finance remains one of the most common conduits for money laundering and terrorist financing, institutions must integrate trade-based controls, transaction monitoring, and trade-specific risk assessments.

Letter of Credit in AML/CFT Frameworks

Institutions issuing, advising, or confirming letters of credit must incorporate these controls:

Customer and Counterparty Due Diligence

  • Conduct enhanced due diligence when a letter involves higher-risk buyers or sellers, especially in jurisdictions with weak controls or high corruption.
  • Verify beneficial ownership, corporate structure, trade history, and reputation of parties involved.
  • Assess whether the underlying trade is consistent with the applicant’s business, volume, and pattern.

Documentary Review and Integrity Checks

  • Confirm that shipping documents, invoices, bills of lading, certificates of origin, and other trade paperwork are valid and consistent.
  • Check for discrepancies in description, quantities, valuations, routing, or destination that may signal trade-based money laundering.
  • Ensure that treaties, certifications, and trade permits are genuine and timely.

Sanctions, Watchlists, and Restricted Counterparties

  • Screen all parties (buyer, seller, intermediaries) against sanctions lists, PEP (politically exposed persons) lists, and high-risk entity registers.
  • Apply greater scrutiny when deals involve sanctioned countries or dual-use goods with proliferation risk.
  • Consider rejecting or escalating letters of credit that involve flagged counterparties or geographies.

Trade-Based Money Laundering (TBML) Risk Mitigation

  • Monitor for typical TBML indicators in letter of credit transactions, such as over- or under-invoicing, multiple routing points, unnecessary intermediaries, or circular trade.
  • Set rules for unusual trade volumes, complex supply chains, and deviations from expected trading patterns.
  • Deploy specialised trade-finance monitoring tools integrated with product and channel risk models.

Ongoing Monitoring and Audit

  • Review LC transactions post-issuance to verify fulfillment of goods delivery, document matching, and fund movement.
  • Analyse patterns across multiple letters of credit to detect networks of counterparties, repeated shell entities, or suspicious behaviour.
  • Ensure internal audit functions and compliance teams perform frequent reviews of LC portfolios for hidden risk exposures.

Key Components of a Letter of Credit

Parties Involved

  • The applicant (buyer) who requests the issuing bank to issue the LC.
  • The beneficiary (seller) who will receive payment once documentary conditions are fulfilled.
  • The issuing bank that creates the LC and provides a guarantee of payment.
  • Advising or confirming the bank (if applicable) that tells the beneficiary and may add its guarantee.
  • Transporters, intermediaries, and logistics providers that handle the goods and associated documentation.

Documentary and Payment Terms

  • Description of the underlying goods, services, or materials.
  • Shipping terms, destination, delivery date, and transit instructions.
  • Required documents such a commercial invoice, bill of lading, insurance certificate, certificate of origin, and inspection certificate.
  • Expiry date of the LC and place of presentation for the documents.
  • Payment method (sight payment, deferred payment, acceptance, negotiation) and currency terms.

Types of Letters of Credit

  • Irrevocable: Cannot be cancelled or amended without the consent of all parties.
  • Revocable: Can be amended or terminated by the issuing bank without the beneficiary’s consent (rare in modern trade).
  • Confirmed: A second bank adds its guarantee to the beneficiary.
  • Standby: Serves as a payment guarantee instead of a trade instrument.
  • Transferable: Allows the beneficiary to transfer rights to another party, often used when intermediary suppliers are involved.

Examples of Risk Scenarios

High-Risk Jurisdiction Exposure

A letter of credit is issued for goods shipped from a country with weak AML/CFT controls and a history of trade fraud.

The buyer is unknown to the bank, and shipping routes involve multiple trans-shipments.

The institution must treat the LC as a high inherent risk and apply robust mitigation.

Over-Invoicing and Under-Invoicing

An LC invoice shows goods valued at double their typical market price.

There is only minimal transport cost and destination data. The discrepancy signals potential layering or extraction of illicit funds.

The effects may mirror trade-based money-laundering techniques.

Multiple Shell Companies in the Supply Chain

An LC is requested for goods that are subcontracted through at least three shell companies in different jurisdictions.

The documents include a bogus inspection certificate, and the payment is routed through a third-country bank.

The bank must escalate and potentially reject the transaction.

Standby Letter of Credit for Reimbursement Guarantee

An institution issues a standby LC on behalf of a client who claims the guarantee is for equipment performance.

The bank discovers the guarantee has been requested by a newly-established offshore entity with no relevant trading history.

The standby LC becomes a payment risk rather than a trade instrument.

Mismatch Between Goods and Business Activity

An applicant’s core business is software development, yet the LC covers “raw minerals”.

The mismatch raises questions about the legitimacy of the trade and the underlying purpose.

The bank must investigate supply-chain validity.

Impact on Financial Institutions

Letters of credit can pose layered risk exposures:

  • Increased operational risk due to high-volume cross-border activity with complex documentation.
  • Elevated ML/TF risk because of potential misuse through trade chains and layered payment flows.
  • Correspondent banking risk, when the bank uses overseas counterparties for LC confirmation or negotiation.
  • Regulatory risk if the institution fails to detect misuse, leading to sanctions or enforcement actions.
  • Reputational risk with clients, partners, and regulators if trade-finance controls are weak or circumvented.

Challenges in Managing Letter of Credit Risk

Several hurdles exist for effective AML/CFT control of letters of credit:

  • The complexity of trade transactions and documentation means potential fraud or manipulation may be hard to detect.
  • Data fragmentation across multiple banks, transporters, and jurisdictions impedes a holistic view.
  • Rapid issuance and negotiation of LCs may reduce time for thorough review.
  • Unstandardised or falsified documents are often hard to validate, especially in weak jurisdictions.
  • Integration of trade-finance risk into standard AML monitoring systems is technically demanding and resource-intensive.

Regulatory Oversight & Governance

  • Regulatory frameworks emphasise risk-based approaches to trade finance, including letters of credit, under global standards such as the Financial Action Task Force (FATF).
  • Domestic regulators require banks to include trade-finance tools such as LCs in their AML/CFT programmes, perform enhanced oversight and maintain sound controls.
  • Internal audit and compliance committees must ensure that trade-finance units operate within risk-appetite levels and report exposures, trends, and exceptions regularly.

Importance of Letter of Credit Awareness

An institution’s ability to recognise and mitigate risks associated with letters of credit is a key component of a robust AML/CFT programme.

Because LCs blend trade and payment flows, they offer sophisticated criminals opportunities to hide and move illicit funds.

By implementing strong trade-finance controls aligned with risk-based frameworks, institutions can:

  • Detect and deter trade-based money-laundering attempts.
  • Ensure the integrity of cross-border trade flows.
  • Maintain correspondent banking relationships by demonstrating strong oversight.
  • Support transparency and auditability in high-risk trade corridors.
  • Uphold the institution’s reputation and regulatory compliance posture.

Related Terms

  • Trade Finance
  • Trade-Based Money Laundering
  • Letter of Credit Confirmation
  • Eligibility Screening
  • Beneficiary Risk
  • Supply-Chain Risk

References

Ready to Stay
Compliant—Without Slowing Down?

Move at crypto speed without losing sight of your regulatory obligations.

With IDYC360, you can scale securely, onboard instantly, and monitor risk in real time—without the friction.

Get a Demo
charts charts-dark