There are two basic forms of Letters of Credit:
Standby (SBLC) and Documentary (DLC).
Documentary Letters of Credit can be either Revocable or Irrevocable, although the first is extremely rare. Irrevocable Letters of Credit can be Confirmed or Not Confirmed. Each type of Credit has advantages and disadvantages for the Buyer and for the Seller, which this information will review. Charges for each type will also vary. However, the more the banks assume risk by guaranteeing payment, the more they will charge for providing the service.
DOCUMENTARY LETTER OF CREDIT (DLC)
A Letter of Credit is a document issued typically by a financial institution that provides an irrevocable payment undertaking to a Beneficiary against complying documents as stated in the Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary Credit, abbreviated as DC or D/C, documentary Letter of Credit, or simply as Credit (governed by UCP-600 and eUCP ). Once the Beneficiary, or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC (providing the documents complying with the terms and conditions of the LC as well as the applicable UCP and international standard banking practice), the issuing bank or confirming bank, if any, is obliged to honor the LC, irrespective of any instructions from the Applicant to the contrary. In other words, the obligation to honor (usually payment) shifts from the Applicant to the issuing bank or confirming bank, if any. Non-banks can also issue Letters of Credit, however, parties must balance potential risks. The LC can also be the source of payment for a transaction, meaning that an exporter will be paid by redeeming the Letter of Credit. Letters of Credit are used currently primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. The parties to a Letter of Credit are usually a Beneficiary who is to receive the money, the issuing bank of whom the Applicant is a client, and the advising bank of whom the Beneficiary is a client. Today almost all Letters of Credit are irrevocable, (i.e. cannot be amended or cancelled without prior agreement of the Beneficiary, the issuing bank and the confirming bank, if any).
IRREVOCABLE DOCUMENTARY LETTER OF CREDIT (ILOC)
This is the most common form of Credit used in international trade. Irrevocable Credits may not be modified or canceled by the Buyer. The Buyer's issuing bank must follow through with payment to the Seller as long as the Seller complies with the conditions listed in the Letter of Credit. Both the Buyer and the Seller must approve changes in the Credit. If the documentary Letter of Credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable. This is often used in international transactions.
There are two forms of irrevocable Letter of Credits
REVOCABLE DOCUMENTARY LETTER OF CREDIT
Revocable Credits may be modified or even canceled by the Buyer without notice to the Seller. Therefore, they are generally unacceptable to the Seller. Enter your text here
(the irrevocable Credit not confirmed by the advising bank). In an unconfirmed Credit, the Buyer's bank issuing the Credit is the only party responsible for payment to the Seller. The Seller's advising bank pays only after receiving payment from the issuing bank. The Seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.
(the irrevocable confirmed Credit). In a confirmed Credit, the advising bank adds its guarantee to pay the Seller to that of the Buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the Seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable Letters of Credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the Seller is unfamiliar with the bank issuing the Letter of Credit or when the Seller needs to use the confirmed Letter of Credit to obtain financing from its bank to fill the order. A confirmed Credit is more expensive because the bank has added liability.
STANDBY LETTER OF CREDIT (SBLC)
A stipulation that states a Letter of Credit will be called back if the payer defaults. Standby Letters of Credit are issued by banks to stand behind monetary obligations, to insure the refund of advance payment, to support performance and bid obligations, and to insure the completion of a sales contract. The Credit has an expiration date. The Standby Letter of Credit is often used to guarantee performance or to strengthen the credit-worthiness of a customer. A bank will issue a Standby Letter of Credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract between the Beneficiaries. The parties involved with the transaction do not expect that the Letter of Credit will ever be drawn upon.
TRANSFERABLE LETTER OF CREDIT
This type of Credit allows the Seller to transfer all or part of the proceeds of the original Letter of Credit to a second Beneficiary, usually the ultimate supplier of the goods. The Letter of Credit must clearly state that it is transferable for it to be considered as such. This is a common financing tactic for reseller, intermediaries, and is common in East Asia.
REVOLVING LETTER OF CREDIT
With a Revolving Letter of Credit, the issuing bank restores the Credit to its original amount once it has been used or drawn down. Usually, these arrangements limit the number of times the Buyer may draw down its line over a predetermined period.
RED CLAUSE LETTER OF CREDIT
Red Clause Letters of Credit provide the Seller with cash prior to shipment to finance production of the goods. The Buyer's issuing bank may advance some or all of the funds. The Buyer, in essence, extends financing to the Seller and incurs the risk for all advanced credits.
DEFERRED PAYMENT (Usance) LETTER OF CREDIT
In Deferred Payment Letters of Credit, the Buyer accepts the documents related to the Letter of Credit and agrees to pay the issuing bank after a fixed period. This Credit gives the Buyer a grace period for payment.
ASSIGNMENT OF PROCEEDS
The Beneficiary of a Letter of Credit may assign all or part of the proceeds under a Credit to a third party (the assignee). However, unlike a transferred Credit, the Beneficiary maintains sole rights to the Credit and is solely responsible for complying with its terms and conditions. For the assignee, an assignment only means that the paying bank, once it receives notice of the assignment, undertakes to follow the assignment instructions, if and when payment is made. The assignee is dependent upon the Beneficiary for compliance, and thus this arrangement is riskier than a transferred Credit. Before agreeing to an assignment of proceeds arrangement, the assignee should carefully review the original Letter of Credit.