Types of Letters of Credit: Ensuring Safe Transactions in International Trade

A Letter of Credit (LC) is a financial document issued by a bank that guarantees payment to the seller in a business transaction. It is particularly useful when the buyer and seller do not have an established relationship or when the transaction involves international trade. In simpler terms, an LC ensures that the seller gets paid even if the buyer is unable to fulfill the payment.

If the buyer cannot pay the agreed amount, the bank steps in and covers the remaining or entire payment. To issue an LC, banks usually require the buyer to pledge assets, such as cash or securities, and charge a fee based on the size of the letter of credit.

What is a Letter of Credit?

A Letter of Credit serves as a promise from the bank that the seller will receive the payment for goods or services, especially in larger transactions. It is widely used in international trade, where parties from different countries may not have strong relationships or familiarity with each other’s legal systems.

In these scenarios, an LC acts as insurance for the seller, making sure they receive payment regardless of any issues on the buyer’s end. The most common types of letters of credit include commercial letters of credit, standby letters of credit, and various others, each designed for specific trade or payment conditions.

Key Points to Remember:

• Letters of credit guarantee the seller will be paid, even in complex transactions.
• Banks take on the responsibility of ensuring payment to the seller.
• These documents are mostly used in international trade, where trust between buyers and sellers can be limited.
• Various types of letters of credit serve different purposes, such as commercial, standby, revocable, and irrevocable letters of credit.

Why are Letters of Credit Important?

International trade involves dealing with long distances, different laws in each country, and limited personal interaction between parties. Letters of credit act as a reliable payment solution in such cases, providing security to both buyers and sellers. The International Chamber of Commerce oversees the use of letters of credit to ensure uniform practices worldwide.

Who is Involved in a Letter of Credit?

• Applicant: The buyer or importer who requests the bank to issue a letter of credit.
• Issuing Bank: The bank that issues the LC on behalf of the buyer.
• Beneficiary: The seller or exporter who is guaranteed payment under the letter of credit.

How Does a Letter of Credit Work?

The process of issuing a letter of credit begins with an agreement between the buyer and seller. Both parties discuss and agree on the terms, conditions, and deadlines of the transaction before the letter of credit is submitted to the bank for approval.

Before a bank agrees to issue a letter of credit, it usually evaluates the buyer’s financial health, including their credit score, assets, and liabilities. This helps ensure that the buyer is capable of fulfilling their obligations.

If the buyer defaults on the payment, the bank steps in to cover the entire amount or the remaining balance. If the buyer has already made part of the payment, the bank pays the rest to the seller.

Common Types of Letters of Credit

Revocable Letter of Credit

This type allows the bank or the buyer to cancel or modify the LC without notifying the seller. It favors the buyer and is rarely used today because it does not protect the seller.

Irrevocable Letter of Credit

More commonly used, this LC cannot be changed or canceled without the agreement of all parties involved, including the buyer, seller, and bank. This provides security for the seller, ensuring they will be paid as long as they meet the conditions.

Also Read: Difference Between Revocable And Irrevocable Letter Of Credit

Confirmed Letter of Credit

When an additional bank guarantees the payment along with the issuing bank, it becomes a confirmed LC. This is used when the seller does not fully trust the buyer’s bank.

Unconfirmed Letter of Credit

In this case, there is no additional guarantee from a second bank. The responsibility of payment rests solely with the buyer’s bank.

LC at Sight

This type requires the seller’s bank to pay as soon as the necessary documents are presented and verified. It ensures quick payment upon the completion of the terms.

Usance Letter of Credit (Deferred Payment LC)

In this type, the payment is delayed for a specific period after the seller delivers the goods. This gives the buyer time to make the payment, while the seller receives assurance of eventual payment.

Back-to-Back Letter of Credit

This involves two LCs used in the same transaction. It is commonly used when there is a middleman who buys from one party and sells to another.

Transferable Letter of Credit

Used when a middleman is involved, this LC allows the payment to be transferred to another beneficiary, typically when a company sells products made by another company.

Un-transferable Letter of Credit

This LC can only be used by the original beneficiary, meaning it cannot be transferred to another party.

Standby Letter of Credit (SBLC)

Often used in the U.S., this acts as a backup plan. If the buyer fails to fulfill their payment obligations, the seller can request the bank to make the payment.

Freely Negotiable Letter of Credit

Any bank that is willing to pay or negotiate the LC can become the nominated bank in this type of LC, providing flexibility to the seller.

Revolving Letter of Credit

This LC automatically reinstates the payment amount after each transaction, which is helpful for regular, repeated transactions.

Red Clause Letter of Credit

In this LC, the seller receives part of the payment in advance before the goods are shipped. It helps cover the seller’s expenses, such as purchasing materials or packaging.

Green Clause Letter of Credit

Similar to a Red Clause LC, but with added features like advance payment for warehousing and insurance costs, in addition to production expenses.

Conclusion

Letters of credit offer a reliable method to ensure that both buyers and sellers feel secure during large transactions, particularly in international trade. With several types of LCs available, businesses can choose the one that best fits their needs. Whether it’s ensuring quick payments, deferring payments, or adding multiple guarantees, LCs play a crucial role in maintaining trust and ensuring smooth business operations across borders.
Also Read: Diverse Types of Export Letters of Credit: Clauses, Payment Terms, and More