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Types of letter of credit

Different types of letter of credit

A Letter of Credit is an assured form of payment term widely used for long- distance and international commercial transactions.It is governed by the law of contracts issued against an assurance of securities or cash. In aLetterof Credit (LC) transaction, a bank commences to make payment to a trader or beneficiary on submission of documents stipulated in the LC.It allows the seller to undoubtedly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks. Letters of credit have become a crucial aspect of international trade , due to differing laws in each country and difficulty in knowing each party personally.

Let’s see its benefits and drawbacks:

Advantages of Letter of Credit

  • Expand business and reach out customers internationally.
  • Seller receives money on fulfilling terms.
  • Control the time period for shipping of the goods
  • Providing a letter of credit allows worthiness.
  • Eliminates Importing Country’s Political Risks via Confirmation

Disadvantages of Letter of Credit

  • Possibility associated with Shipment of Low-Quality Goods
  • Possibility of misuse-fraud risk
  • Long process formalities
  • Higher bank fees

Various types of letter of credit are used for international dealings. They are as follows:

Commercial LC

A commercial letter of credit is direct payment method or acts as the primary payment mechanism between the customer and the beneficiary; that is, the issuing bank makes the actual payments to the beneficiary every time. It provides security to buyers and sellers.

Transferable LC

A Transferable Credit is one in which a beneficiary can transfer his rights to third partiesThis letter comes with the option that allows a trader to transfer its rights and obligations to a new supplier without any difficulty. It is commonly used when the beneficiary is an intermediary for the real supplier of the goods and services or is one of a group of suppliers. In cases where the beneficiary is an intermediary for the real suppliers of goods and services, the payment has to be transferred to the actual suppliers of goods and services. So, on the contrary this letter helps the transfer of the payment to the next supplier in the chain of trade.

It is beneficial in those cases when the Seller is not one and only builder of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC's for other parties.

Un-Transferable LC

It is a letter of credit that cannot be assigned by seller to another party. The payments are prevented from being transferred to any third parties, as the beneficiary is the recipient. In international commerce, all credits are untransferable.

Commercial LC

A commercial letter of credit is direct payment method or acts as the primary payment mechanism between the customer and the beneficiary; that is, the issuing bank makes the actual payments to the beneficiary every time. It provides security to buyers and sellers.

Revocable LC

The terms and conditions of revocable LC can be amended or cancelled by the Issuing Bank. This cancellation can be done without prior notice to the beneficiaries.

Irrevocable LC

An irrevocable credit is a credit, the terms and conditions of which cannot be cancelled or modified without consent of the beneficiary. Hence,commitments given in the LC are bounded by the opening bank.Almost all letters of credit now are irrevocable, because revocable letters of credit simply do not provide the security that most beneficiaries want.

Standby LC

This LC gives more flexible collaboration opportunity to Seller and Buyer. It is like a performance bond or guarantee issued by the bank in the form of the LC. The Bank will fulfills the LC when the Buyer fails to fulfil payment liabilities to Seller. The beneficiary of this type of letter of credit can provide the required documents as mentioned in the LC document and can ask for its claim.

Confirmed LC

In this type of letter of credit when the letter is confirmed, the bank guarantees that payment will be made. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to pay. Normally the seller’s bank becomes an advising bank when a normal letter of credit is received andIt also delivers or advises the buyer regarding the receipt of LC with no responsibility towards it.

This will be granted “confirmed” status once the exporters confirming bank has added its obligation to the issuing bank. The commitment will either be in the form of a guarantee or Assurance of Payment.

Unconfirmed LC

There is no confirmation from the exporter’s advisory bank in an Unconfirmed Letter of Credit as it is only guaranteed by the issuing bank. However, this type of confirmation, payment could be at risk in areas of economic instability or political uncertainty.

Revolving LC

In case of multiple payments, the revolving letter of credit is used. When the seller and buyer ready to do Business continuously they need to issue letter every time for every transaction which is time consuming and becomes a headache. The revolving letter of credit allows businesses to use a single letter of credit for Many numbers of transactions until the letter expires which can be used up to one year.

Back to Back LC

A back-to back letter of credit grant mediators to connect buyers and sellers. Dual letters of credit are used so that each party gets paid apart. Amediator gets paid by the buyer, and a supplier gets paid by the mediator. The final buyer and the mediator use a “master” letter of credit, and the intermediary and supplier use a letter of credit based on the master letter.This type of letter is generally opened for suppliers.

Red Clause LC

A red clause letter of credit permits the seller to request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. It is termed as red clause because it is usually printed in red on the document to draw attention to "advance payment" term of the credit.

Sight LC

Under this LC, it is payable as soon as the documents have been verified and presented to the corresponding bank. A sight letter of credit is more prompt than other forms of letters of credit.

Conclusion

The letter of credit has become an important tool for the business and have many different variations. Likewise, each of these different types of Letters of Credit help protect traders on both sides of a transaction from the many difficulties associated with cross-border trade.

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FREQUENTLY ASKED QUESTIONS

1. What is revocable letter of credit?

Revocable LC allows the issuing bank or the buyer to alter the terms at any time without any notification to the seller or beneficiary.


2. What is irrevocable letter of credit?

Irrevocable LC doesn’t allow the issuing bank to make any changes without the approval of all the parties.


3. Can LC be cancelled?

Irrevocable letter of credit can be cancelled only with consent of the beneficiary as well as the applicant along with the confirming bank. A revocable LC can be cancelled at any time without prior intimation to the involved parties and beneficiary.


4. What are the documents required for LC?

  • Commercial Invoice
  • Bill of lading
  • Warranty of title
  • Letter of Indemnity
  • Transport documents
  • Insurance documents
  • Financial documents
  • Commercial documents
  • Official documents

5. How many types of letter of credit are there?

There exists following types of LC depending upon the purpose and buyer’s need:

  • COMMERCIAL LC
  • EXPORT/IMPORT LC
  • TRANSFERABLE LC
  • UN-TRANSFERABLE LC
  • REVOCABLE LC
  • IRREVOCABLE LC
  • STANDBY LC
  • CONFIRMED LC
  • UNCONFIRMED LC
  • REVOLVING LC
  • BACK TO BACK LC
  • RED CLAUSE LC
  • GREEN CLAUSE LC
  • SIGHT LC
  • DEFERRED PAYMENT LC