Letters of Credit: What Are The Different Types?
In the trade finance market, there are really only two basic forms of letters of credit: The Standby Letter of Credit (SBLC) and Documentary Letter of Credit (DLC).
Revocable or Irrevocable Documentary Letters of Credit
Documentary Letters of Credit (DLC) can be issued as either revocable or irrevocable. Most all Documentary Letters of Credit are issued as an irrevocable DLC as revocable DLCs are very rare.
Revocable Documentary Letters of Credit
Revocable Documentary Letters of Credit may be altered or even canceled by the buyer without any notice to the seller.
Due to this, they are more often than not unacceptable to the seller.
Irrevocable Documentary Letters of Credit
Being the most commonly used type of letter of credit in global trade, Irrevocable Documentary Letters of Credit cannot be altered or canceled by the buyer.
As long as the seller complies with the terms and conditions of the letter of credit, the buyer's issuing bank must make payment to the seller when it is.
Any alterations to the Irrevocable Documentary Letter of Credit must be approved by both parties involved in the transaction.
Unless stated as revocable, a Documentary Letter of Credit automatically is considered irrevocable.
Confirmed or Unconfirmed Documentary Letters of Credit
Irrevocable Documentary Letters of Credit are issued as confirmed or not confirmed. Both types of credit have their own advantages and disadvantages for the buyer and seller.
The cost of each type varies as well. In general, the more risk a bank assumes by guaranteeing payment, the higher the cost will be for providing the letter of credit.
Unconfirmed Documentary Letters of Credit
This type of letter of credit is an irrevocable credit that is not confirmed by an advising bank.
In an Unconfirmed Documentary Letter of Credit, the buyer's issuing bank is the only party responsible for guaranteeing payment to the seller.
Payment is made to the seller by the advising bank only after it has received payment from the issuing bank. The advising bank is simply a middleman between the issuing bank and the seller.
Confirmed Documentary Letters of Credit
This type of letter of credit is an irrevocable credit that is confirmed by an advising bank.
The advising bank and issuing bank both guarantee payment to the seller when demanded.
The advising bank first reviews and confirms that all of the documentary requirements in the credit are met and pays the seller.
The advising bank then goes directly to the issuing bank to receive payment.
Confirmed Irrevocable Documentary Letters of Credit are often used when trade is done in an area where political, social, or instability are common.
They are also common when the seller is unfamiliar with the bank or financial institution issuing the letter of credit, or when a seller needs to obtain bank financing with the use of the Confirmed Documentary Letter of Credit.
A Confirmed Documentary Letter of Credit is usually provided for a higher fee as the bank takes on more liability.
Standby Letters of Credit
This type of letter of credit is a payment or performance guarantee utilized throughout the world.
Standby Letters of Credit (SBLC) are also often referred to as non-performing letters of credit because they are usually only used as a backup or an insurance policy should the buyer fail to pay the seller.
The Standby Letter of Credit (SBLC) allows a customer establish rapport with a seller by showing that it can and will fulfill its payment commitments to the seller.
These types of letters of credit can be used to guarantee full payment of a contract, repayment of a loan, or payment for goods that are delivered by a third party.
The seller/beneficiary of the Standby Letter of Credit receives payment from the issuing bank by demanding it directly to issuing bank.
Standby Letters of Credit are usually much less complicated and require fewer documentation requirements than Irrevocable Documentary Letters of Credit.
Back-to-Back Letters of Credit
A Back-to-Back Letter of Credit is when a nontransferable, existing letter of credit is used for collateral for opening a fresh, new letter of credit.
Import companies often use Back-to-Back Letters of Credit to pay the buyer’s end supplier while being the middleman.
An import company receives a letter of credit from the buyer and then immediately opens another new letter of credit in favor of the supplier. The first letter of credit is used as collateral for the second letter of credit.
Deferred Payment Letters of Credit
In a Deferred Payment Letter of Credit, the buyer agrees to pay the issuing bank after a fixed period agreed upon in the letter of credit’s documents.
Red Clause Letters of Credit
A Red Clause Letter of Credit provides the seller advanced cash from the buyer’s issuing bank before goods are shipped in order to finance the production of the goods.
In this, a buyer can essentially extend financing to a seller, by guaranteeing all of the advanced money.
Revolving Letters of Credit
A Revolving Letter of Credit is a letter of credit that is restored to its original amount as soon as been used or drawn down.
Many times, these types of letters of credit limit the number of times a buyer can draw down on its line over a particular predetermined period.
Transferable Letter of Credit
This type of letter of credit allows a seller/beneficiary to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the end supplier of the goods or service.
To be considered as a Transferable Letter of Credit, the letter of credit must clearly state that it is transferable.
This is most commonly used for middlemen importer/exporters all across the world.
Assignment of Proceeds
If needed, a beneficiary may assign all or a part of a letter of credit to a third party, but, unlike a Transferable Letter of Credit, the beneficiary maintains sole rights to the letter of credit and is solely responsible for complying with its terms and conditions.
For the third party who the letter of credit was assigned to, an assignment only means that the paying bank follows the assignment instructions if and when payment is to be made.
This type of deal is riskier as the third party involved is dependent upon the beneficiary for compliance.
