What are Letters of Credit?

Commercial Letter of Credit

Often called an “International Letter of Credit,” this provides a direct payment in which the issuing bank makes the payment to the beneficiary seller’s bank. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the recipient only when the holder cannot. Here a bank acts as a neutral third party and will release funds when all the conditions of the agreement have been met.

Revolving Letter of Credit

This kind of Letter of Credit allows a client to make any number of draws within a specific limit during an exact period. A revolving letter of credit can be used for multiple payments. This is generally used when a buyer and Seller expect to do Business continually; both parties may prefer not to obtain a new letter of credit for every transaction. This type of letter of credit allows businesses to use a single letter of credit for numerous transactions until the letter expires (typically up to one year).

Traveler’s Letter of Credit

For those going overseas, this Letter of Credit will guarantee that issuing banks will honor drafts made at certain foreign banks.

Standby Letters of Credit

These work slightly differently than most other types of Letters of Credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the buyer can prove it did not receive what was agreed upon. This is used more as insurance for riskier transactions and less as a means of facilitating exchange.

Irrevocable Letters of Credit

These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed.

Confirmed Letter of Credit

When a Letter of Credit is confirmed, another bank (presumably one that the beneficiary trusts) guarantees that payment will be made. Exporters might not trust a bank that issues a letter of credit on behalf of a buyer (because the exporter is not familiar with that bank, for example, and is not sure if payment will ever arrive), so they might require that a bank in their home country confirm the letter. If the issuing bank fails to pay—and the exporter can meet all of the requirements of the Letter of Credit—the confirming bank will have to pay the exporter (and try to collect from the issuing bank later).

Red Clause Letter of Credit

With a red clause, the beneficiary has access to cash upfront. The buyer allows for an unsecured loan to be issued as part of the letter of credit, which is essentially an advance on the rest of the payment. The Seller or beneficiary can then use the money to buy, manufacture, or ship goods to the buyer.

Deferred Payment Letter of Credit

With this type of Letter of Credit, payment does not happen immediately after the documents are accepted. Some agreed-to period passes before the Seller is paid. A deferred payment Letter of Credit is naturally a better deal for buyers than for sellers. These are also known as term or usance letters of credit.

Sight Letter of Credit

Payment under a Sight Letter of Credit occurs as soon as the beneficiary submits acceptable documents to the appropriate bank. The bank has a few days to review the documents and ensure that they meet the requirements in the letter of credit. If the documents are compliant, payment is made immediately.

All the Letters of Credit available on the market work in their ways. The buyer and the Seller in a trade transaction go over the options available and decide on a type of Letter of Credit that fits their needs, and they both agree to. From there, the two parties involved must set the terms by which the transaction will be deemed completed, and the Letter of Credit can thus be executed.

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing bank or non-bank lender for review.

The lenders will then review and validate the parties being represented by the bank in the transaction. For example, the buyer’s lender will verify the buyer has the collateral needed for the lender to provide the guarantee and secure the funds.

In the Letters of the Credit industry, the importer is called as the applicant or buyer. The applicant plays a vital role in a letter of credit transactions from beginning to end. A Letter of credit is not a sales contract.

The letter of credit is an independent structure that stands apart from the sales or other deals on which it may be based. Therefore, it should be kept in mind that a well-structured sales contract protects the party, which behaves in goodwill against various kinds of risks. Once the signature of the sales contract, the buyer applies to their bank to have the letter of credit issued in favor of the exporter.

The buyer has to make sure that the letter of credit application must be following the terms of the sales agreement. After the buyer applies to a lender for the issuance of a letter of credit. The issuing lender requests the Business to fill an application form, which is called the “Letter of Credit Application Form” or “Documentary Letter of Credit – Application Form.”

This is now the point whereby the issuing lender will evaluate the Letter of Credit application. Upon final approval, the issuing lender produces a Letter of Credit and sends it to the buyer for approval. Once the transaction is completed on the part of the Seller, the seller can either demand payment from the buyer or draw funds directly from the Letter of Credit. Another option the “beneficiary” Seller has is to assign the benefits to someone else in what’s called a “transferable letter of credit.”

They could, for example, transfer the interest to their corporate office, a lender, or someone else to whom they want to give the funds. Whoever ends up with a confirmed letter of credit can then draw the cash value from the issuing bank, like cashing a check.