Commodity Trade Finance and Letters of Credit
A letter of credit is a bank's promise to pay a commodity seller once shipping documents prove the cargo was loaded — it substitutes the bank's credit for the buyer's, letting strangers on opposite sides of the world trade cargo worth millions with confidence.
A commodity trader in Singapore agrees to sell a cargo of soybeans to a buyer in Rotterdam neither has met before. Neither wants to ship or pay first without proof the other side will hold up their end. A letter of credit (LC) solves this: the buyer's bank promises to pay the seller a fixed amount as soon as the seller presents specified documents — a bill of lading proving the cargo was loaded, an inspection certificate, an insurance policy — regardless of any dispute about the goods themselves. The bank's creditworthiness, not the buyer's, backs the trade.
A letter of credit pays against documents, not against the actual physical goods — if the paperwork matches exactly what the LC specifies, the bank must pay, even if the cargo itself turns out to be short or damaged, which is why disputes in commodity trade finance are fought over document wording, not just cargo quality.
Worked example
A seller ships $5 million of crude oil and presents a bill of lading, certificate of origin, and quality certificate to the buyer's bank exactly matching the LC's terms. The bank is obligated to pay the $5 million within the agreed timeframe, even if the buyer later claims the oil delivered was off-spec — that dispute gets resolved separately, between buyer and seller, and does not stop the documentary payment from going through.
That strictness cuts both ways. If even one document is inconsistent with the LC's wording — a misspelled vessel name, a date outside the shipping window — the bank can legally refuse payment until the discrepancy is fixed, which is why commodity trading desks employ specialists whose entire job is checking documents line by line before presentation.
Further reading
- ICC, Uniform Customs and Practice for Documentary Credits (UCP 600)