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letter of Credit

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What is a Letter of Credit?

A letter of credit, or “credit letter” is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.

What are the Types of letter of Credit?

Commercial Letters of Credit

Commercial letters of credit are mainly used as a primary payment tool in international trade.

Commercial letter of credit is the correct type of credit that should be used when an importer pays transaction amount directly to an exporter via letter of credit.

Majority of commercial letters of credit are issued subject to the latest version of UCP (Uniform Customs and Practice for Documentary Credits).

Letter of credit rules are published by a non-governmental international institution called ICC (International Chamber of Commerce).

Stand By LC

A letter of credit that assures the payment if the buyer does not pay. After fulfilling all the terms under SBLC, if the seller proves that the promised payment was not made. In this situation, the bank will pay to the seller. In a nutshell, it does not facilitate a transaction but guarantees the payment. It is quite similar to a bank guarantee.

Confirmed LC

Which the seller or exporter acquires the guarantee of payment from a confirming bank (also called the second bank). This is primarily to avoid the risk of non-payment from the first bank.

If a letter of credit’s payment undertaking is guaranteed by a second bank, in addition to the bank originally issuing the credit this kind of credit is called confirmed letter of credit.

The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable credits can be confirmed.

Unconfirmed LC

A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank.

Transferable LC

A letter of credit that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such LC allows the beneficiary to provide its own documents but transfer the money further.

Un- Transferable LC

A letter of credit that doesn’t allow the transfer of money to any third parties. The beneficiary is the only recipient of the money and cannot further use the letter of credit to pay anyone.

Revocable LC

An LC that issuing bank or the buyer can alter any time without any notification to the seller/beneficiary. Such types of letters are not used frequently as the beneficiary is not provided any protection. 

Irrevocable LC

An LC that does not allow the issuing bank to make any changes without the approval of all the parties.

Revolving LC

When a single LC is issued for covering multiple transactions in place of issuing separate LC for each transaction is called revolving LC. They can be further classified into Time Based (Could be Cumulative or Non-Cumulative) and Value-Based.

Back To Back LC

Back to back LC is an LC which commonly involves an intermediary in a transaction. There are two letters of credit, the first issued by the bank of the buyer to the intermediary and the second issued by the bank of an intermediary to the seller.

Red Clause LC

Letter of credit that carries a provision (traditionally written or typed in red ink) which allows a seller to draw up to a fixed sum from the advising or paying-bank, in advance of the shipment or before presenting the prescribed documents. The advance is paid against the written confirmation from the seller and the receipt.

Green Clause LC

An LC that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods.

Sight LC

A letter of credit that demands payment on the submission of the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter. 

Deferred LC

An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. It is also known as Usance LC.

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