Definition of Letter of Credit

 Types of Letters of Credit (LC)

Various types of Letters of Credit (LC) prevail in trade transactions. In this post, we are classifying them by their purpose. Commercial, Export / Import, Transferable and Non-Transferable, Revocable and Irrevocable, Standby, Confirmed, and Unconfirmed, Revolving, Back-to-Back, Red Clause, Green Clause, Sight, Deferred Payment, and Direct Pay LC.

A Letter of Credit is an essential financial tool in trade transactions. In domestic and international markets, trades use the LC to facilitate payments and transactions. A bank or a financial institution acts as a third party between the buyer and the seller and assures the cost of funds on completing certain obligations.

Definition of Letter of Credit

An LC is a financial document provided by a third party (with no direct interest in the transaction), mainly a bank or a financial institution, that guarantees the payment of funds for goods and services to the seller once the seller submits the required documents. A letter of credit has three critical elements – the beneficiary/seller who is the recipient of the LC, the buyer/applicant who buys the goods or services, and the issuing bank that issues the LC on the buyer's request. At times, there is an involvement of another bank as an advising bank that advises the beneficiary.

Table of Contents

1. DEFINITION OF LETTER OF CREDIT

2. TYPES OF LETTERS OF CREDIT

1. COMMERCIAL LC

2. EXPORT/IMPORT LC

3. TRANSFERABLE LC

4. UN-TRANSFERABLE LC

5. REVOCABLE LC

6. IRREVOCABLE LC

7. STANDBY LC

8. CONFIRMED LC

9. UNCONFIRMED LC

10. REVOLVING LC

11. BACK-TO-BACK LC

12. RED CLAUSE LC

13. GREEN CLAUSE LC

14. SIGHT LC

15. DEFERRED PAYMENT LC

16. DIRECT PAY LC

                CONCLUSION

Types of Letters of Credit

There are various types of letters of credit in trade transactions. Some of these are classified by their purpose. The following are the different types of letters of credit: 

Commercial LC

A standard LC is also called a documentary credit.

Export/Import LC

The same LC becomes an export or import LC, 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.

Transferable LC

A letter of credit that allows a beneficiary to transfer further all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such LC allows the beneficiary to provide its documents but transfer the money further.

Un-transferable LC

A letter of credit that doesn't allow the transfer of money to any third parties. The beneficiary is the only recipient of the funds and cannot further use the letter of credit to pay anyone.

Revocable LC

An LC that issuing bank or the buyer can alter at any time without any notification to the seller/beneficiary. Such types of letters are used infrequently as the beneficiary needs to be provided protection.

Irrevocable LC

An LC only allows the issuing bank to make changes with the approval of all parties.

Standby LC

A letter of credit assures the payment if the buyer fails to pay after fulfilling all the terms under SBLC if the seller proves that the promised payment was not made. In this situation, the bank will deliver to the seller. In a nutshell, it does not facilitate a transaction but guarantees payment. It is similar to a blank guarantee.

Confirmed LC

The seller or exporter acquires the guarantee of payment from a confirming bank (also called the second bank). This is primarily to avoid the risk of non-payment from the first bank.

Unconfirmed LC

A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank. Primarily the letters of credit need to be confirmed.

Revolving LC

When a single LC is issued for covering multiple transactions in place of giving a separate LC for each transaction is called a revolving LC. They can be further classified into Time Based (Could be Cumulative or Non-Cumulative) and Value-Based.

 Back-to-Back LC

Back-to-back LC is an LC that commonly involves an intermediary in a transaction. There are two letters of credit, the first issued by the buyer's bank 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

An LC that pays advance to the seller not just against the written undertaking and a receipt, but also a proof of warehousing the goods.

Sight LC

A letter of credit that demands payment on submitting the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter.

Deferred Payment LC

An LC that ensures payment after a certain period. The bank may review the documents early, but the cost 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.

Conclusion

As mentioned above, a letter of credit can vary depending on its purpose. It is in the interest of both the buyer and the seller, to understand all the different types thoroughly and then pick the one which serves the purpose ultimately.