A letter of credit 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 payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
ØApplicant – the buyer in a transaction
ØBeneficiary – the seller or ultimate recipient of funds
ØIssuing bank – the bank that promises to pay
ØAdvising bank – helps the beneficiary use the letter of credit
Types of Letter of Credit
There are various types of letters of credit used in the trade transactions. Some of the letters of credit may be defined by their purpose. The following are the different types of letters of credit:
A standard LC, also called as documentary credit.
The same letter of credit can be called export or import depending on who uses it. The exporter will term it as an exporter letter of credit whereas an importer will term it as an importer letter of credit.
A letter of credit that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such letter of credit allows the beneficiary to provide its own documents but transfer the money further.
A letter of credit that doesn’t allow 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.
A letter of credit that can be altered any time by the issuing bank or the buyer without any notification to the seller/ beneficiary. Such types of letters are not used frequently as the beneficiary is not provided any protection.
A letter of credit that does not allow the issuing bank to make any changes without the approval of the beneficiary.
A letter of credit that is designed to assure the payment if something wrong happens. If the beneficiary proves that the promised payment was not made, a standby LC becomes payable. It does not facilitate a transaction but ensures the payment.
A letter of credit where an advising bank also guarantees the payment to the beneficiary. Only the irrevocable letters of credit are confirmed by the advising bank. The beneficiary has two promises to pay – one from the issuing bank and the other from the advising bank.
A letter of credit that is assured only by the issuing bank and does not need a guarantee by the second bank. Mostly the letters of credit are an unconfirmed letter of credit.
A letter of credit used for several payments instead of issuing letters for each leg of the transaction.
Back to Back LC
A letter of credit which is commonly used in a transaction including an intermediary. 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
A letter of credit that partially pays the beneficiary before the goods are shipped or the services are performed. The advance is paid against the written confirmation from the seller and the receipt.
Green Clause LC
A letter of credit that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods.
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 Payment LC
A letter of credit that ensures payment after a certain period of time. 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.
Direct Pay LC
A letter of credit where the issuing bank directly pays the beneficiary and then asks the buyer to repay the amount. The beneficiary may not interact with the buyer.