What is a letter of credit?
A letter of credit is a guarantee or assurance to the seller that they will get paid on a large transaction. They are especially common in international or foreign exchange transactions. Think of them as a form of payment insurance provided by financial institutions or other accredited parties to the transaction. The earliest letters of credit were common in the 18th century and were called travelers' letters of credit. The most common contemporary letters of credit are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red-term letters of credit, although there are several others.
Commercial letter of credit
This is a standard letter of credit commonly used in international trade. It can also be called a "Documentary Credit" or "Import and Export Credit". 1 The bank acts as a neutral third party to release funds when all the conditions of the agreement are met.
Standby Letter of Credit
This type of letter of credit is different: it offers payment if something doesn't happen. 2 Standby letters of credit do not facilitate a transaction, but provide compensation in the event of a problem. A standby letter of credit is usually similar to a commercial letter of credit, but only pays if the payee (or "beneficiary") can prove they didn't get what was promised in the agreement. Standby letters of credit are a form of insurance that ensures you get paid, and they also guarantee that services will be performed satisfactorily. They can be used with negotiable letters of credit.
Irrevocable letter of credit.
This Letter of Credit may not be cancelled or amended without the consent of the beneficiary (Seller). This Letter of Credit reflects the Bank's (Issuer's) absolute liability to the other party.
Revocable Letter of Credit.
The bank (issuing bank) can cancel or amend this type of letter of credit at the customer's instruction without the prior consent of the beneficiary (seller). After the L/C is revoked, the Bank shall not assume any responsibility to the beneficiary.
Red Clause LC.
The seller may require prepayment of a letter of credit for an agreed amount prior to shipment of the goods and presentation of the required documents. This red clause is so called because it is usually printed in red on the document to draw attention to the "advance payment" clause of the letter of credit.
Revolving letter of credit
A revolving letter of credit can be used for multiple payments.
If buyers and sellers want to repeat business, they may not want to obtain a new letter of credit for each transaction (or each step in a series of transactions). This type of letter of credit allows a business to conduct multiple transactions using a single letter of credit before the letter of credit expires, and the validity period of the letter of credit may be three years or less.
Negotiable letter of credit
A transferable letter of credit can be transferred from one "beneficiary" (payee) to another. They are usually used when an intermediary is involved in a transaction.
Back to back
Back-to-back letters of credit can be used when an intermediary is involved but a negotiable letter of credit is not suitable.
What are the benefits of using a letter of credit?
A letter of credit places the risk of the transaction on the bank rather than the buyer or seller. They provide a secure payment method that ensures funds get where they need to be. Letters of credit also provide parties with the opportunity to incorporate safeguards, regulations or other quality control measures.
How to get a letter of credit?
Many banks offer letters of credit, so you can get one by contacting your bank's representative. Banks with dedicated international trade or business departments are likely to offer letters of credit. If your bank doesn't offer a letter of credit, it may point you to an institution that does.
