The World Bank defines a letter of credit (LC) as a document that “allows the buyer and seller to contract a trusted intermediary (a bank) that will guarantee full payment to the seller provided that he has shipped the goods and complied with the terms of the agreed-upon Letter”. These documents are typically irrevocable, that is, once they’re established, they cannot be changed without the consent of both parties.
The letter from the bank serves as a shield for the buyers & sellers as it seeks to evenly distribute risk between both the parties. The seller is assured of payment when the conditions of the LC are met, while the buyer is reasonably assured of receiving the goods ordered. In case the buyer is unable to make the payment to the seller, the bank that issued a letter of credit must pay the seller, provided the seller meets all of the requirements stated in the letter. Meanwhile, it safeguards buyers in the sense that if they pay somebody to provide a product or service to someone and they fail to deliver, they might be able to get paid using a standby letter of credit.
These can be quite flexible in design & purpose. Therefore, there are different types of letter of credit such as:
Standby letter of credit
Regarded by the World Bank as the safest and most desirable letter of credit, at least from the seller’s point of view, the standby letter of credit is more of a bank guarantee for longer-term projects. In other words, it promises payment to the seller only if the buyer fails to make an arranged payment or otherwise fails to meet pre-determined terms and conditions.
Revolving letter of credit
This documentary credit allows a customer to make any number of draws within a certain limit during a specific time period. They are opened for a stated amount and the drawings under the LC are reinstated as soon as the documents are paid. They can revolve in relation to time or value. It is beneficial when the exporter and importer have frequent dealings of the same nature.
Revocable & irrevocable letters of credit
This documentary credit can be cancelled or amended by the issuing bank at any time and without prior notice to or consent of the beneficiary. Therefore, from an exporter’s point of view, such LCs are not safe. In contrast, an Irrevocable Letter of Credit cannot be cancelled or amended without the consent of all parties concerned.
Commercial Letter of Credit
This is a direct payment method in which the issuing bank makes the payments to the concerned beneficiary on behalf of its customers – that is, the provider of goods and/or services. This contractual agreement between the issuing banks has been used to facilitate payment in international trade. These are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.
Traveler’s Letter of Credit
Designed for those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks. It is typically addressed to a correspondent bank, from which one can draw credit by identifying oneself as the person in whose favor the credit is drawn.
Confirmed Letter of Credit
A contract between the issuing bank and the confirming bank, typically the seller’s bank, it ensures payment under the letter of credit if the holder and the issuing bank default. Usually, this type of an agreement is requested by the issuing bank.
Deferred Payment Letter of Credit
It is an usance credit where, payment will be made by Issuing bank, on respective due dates, determined in accordance with the stipulations of the credit, without the drawing of Bill of Exchange – that is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of a certain person or to the bearer of the instrument.’
Acceptance Letter of Credit
What separates this LC from the former category is that under this credit, Bill of Exchange must be drawn on the specified bank for specified tenor, and the designated bank will accept and honour the same, by making payment on the due dates.
