Different Types of Letters of Credit
A letter of credit, also known as a bank credit letter, payment guarantee letter, or documentary credit, is a legal financial instrument issued by a bank or a financial institution to guarantee the buyer’s payment to the seller. In the event, if the buyer is unable to make the payment or perform the terms and conditions of the contract, the full or remaining amount will be covered by the buyer’s issuing bank to pay the exporters. An LC is a highly-secured and effective form of assuring on-time payment to the exporter while initiating an international transaction. This guide covers the letter of credit and its types. To know more, read our LC guide!
Types of Letter of Credit
How many types of letter of credit an importer-exporter can choose from? There are different types of letter of credit that can be chosen depending on the requirement of your business. Some of them are here as follows:
- 1. Commercial Letter of Credit
- 2. Export/Import LC
- 3. Transferable Bank Credit Letter
- 4. Non-transferable Bank Credit Letter
- 5. Revocable Payment Guarantee Letters
- 6. Irrevocable Payment Guarantee Letters
- 7. Standby Letter Of Credit
- 8. Confirmed LC
- 9. Unconfirmed LC
- 10. Revolving Bank Credit Letter
- 11. Back-to-Back LC
- 12. Red Clause Bank Credit Letter
- 13. Traveler's Letter of Credit
- 14. Credit on Sight/Sight Credit
- 15. Time Credit/Acceptance Credit
Let’s read about different types of letters in detail:
- 1. Commercial Letter of Credit -These types of LCs come with a direct payment method where the issuing bank releases the payment to the beneficiary or exporters.
- 2. Export/Import LC - Whether it is an import or export bank credit letter, it depends on who uses it. To put it simply, if a bank credit letter is used by the exporter, this type of LC will be known as an export documentary credit and vice-versa.
- 3. Transferable Letter of Credit- As the name suggests, this is among those LC types where the beneficiary can transfer his/her right to third parties. It means these payment guarantee letters are transferable to the next beneficiary in the chain and involve a middleman. The original beneficiary requests the bank to transfer either the entire payment or part thereof to the second beneficiary. Here, the first beneficiary acts as a middleman.
- 4. Non-transferable Bank Credit Letter - Contrary to the transferable LC, these letters of credit types cannot be transferred to another beneficiary and the payments can be prevented from getting by any second beneficiary.
- 5. Revocable Payment Guarantee Letters - A revocable LC is among those letter of credit types that which can be amended, canceled by the issuing bank without giving any prior notice to the beneficiaries. This is the reason these types of payment guarantee letters are not used frequently.
- 6. Irrevocable Payment Guarantee Letters - On the other hand, an irrevocable LC is that where the terms and conditions cannot be changed or amended by the bank without the prior consent of sellers. These types of letter of credits are more secure than revocable LCs.
- 7. Standby Letter Of Credit - Standby letter of credit is similar to the bank guarantee where the exporters are entitled to get the payment from the bank in the event of the buyer’s failure to perform the terms and conditions of the contract. In short, it ensures the exporter that the buyer will perform their part to the contract.
- 8. Confirmed LC - A documentary credit can be a confirmed LC when it involves a bank other than the issuing bank to guarantee the documentary credit. This second bank is the confirming bank (seller’s bank). The confirming bank ensures on-time payment to the seller in case if the buyer or issuing bank defaults. In simple words, where a confirming bank adds its own confirmation to the credit, it is known as a confirmed LC. Here, the beneficiary’s bank submits the documents to the confirming bank.
- 9. Unconfirmed LC - On the contrary, an Unconfirmed LC is only assured by the issuing bank and does not involve any second bank’s confirmation. To put it simply, in these kinds of letter of credit, only the issuing bank is liable to make the payment to the seller in case if the buyer defaults.
- 10. Revolving Bank Credit Letter - This type of letter of credit can be used to make plenty of draws within a particular limit during a particular period. The global traders use it in case of shipments that involve a diverse set of goods to be traded within a specific period.
- 11. Back to Back LC - A Back to Back LC is one of those types of credit which is issued when the exporter requests his bank to issue an LC in favor of the supplier to secure raw material. It means there is a second LC issued with another LC as security. You can understand it by taking an example of a middleman buying goods from one party and selling it to another. The bank issues a Back to Back LC backed by the export LC.
- 12. Red Clause Bank Credit Letter - Among types of letters of credit, a Red Clause letter of credit is where the buyer’s issuing bank provides a partial payment to the seller before the shipment of goods or availing of the services. This secures a certain supplier to accelerate the shipping process. It means there is a partial payment before the goods are shipped to the buyer.
- 13. Traveler's Letter of Credit - These are issued to the travelers going abroad with a guarantee that the drafts will be honored by the issuing bank made at foreign banks.
- 14. Credit on Sight/Sight Credit - Also known as LC at sight, in this type of letter of credit, the entrepreneur or businessman can get the payment by presenting the correct documents (like bills of exchange) to the lender with a sight letter. These LCs allow you to take the funds on an instant basis by presenting a sight credit.
- 15. Time Credit/Acceptance Credit - Bills of exchanges that are drawn and paid after a certain period between the lender and the borrower are known as time credit. In these letters of credit, these bills are accepted upon presentation and honored on their respective due dates.
So, now you know that there are various types of letter of credit that an importer-exporter can apply for. To get a letter of credit, the consumer needs to provide a certain document to the issuing bank depending on the type. Before applying for a bank credit letter, both importers and exporters should be aware of all the types of bank credit letters to pick one as per the requirements of their business. Emerio Banque is a leading private institution providing a range of customized, safe, and reliable LCs.
Related Read: Letter Of Credit vs Bank Guarantee
Advantages and Disadvantages of Letters of Credit
In letters of credit, people can easily get products and services from overseas vendors. Buyers' credit improves when their transactions are guaranteed by reputable guarantors, such as banks. Sellers are no longer concerned about the danger of buyer credibility and nonpayment.
It benefits both the client and the vendor. LCs foster trust among the parties. It is also amendable, which means that the rules and regulations of LCs could be amended at any moment with the mutual agreement of both parties. It also minimises the likelihood of disagreement between the trading partners. Letter of credit service, make negotiating easier.
However, the LC raises the buyers' costs. Banks charge a fee for establishing an LC. Letters of Credit obligate both the vendor and the purchaser to meet prescribed obligations within a specific time frame. Also, the monetary institution hasn’t any influence over the product and service quality carried to the client by the seller.
Advantages
• Security: LCs give both parties with a level of security. Sellers are guaranteed payment when they meet the agreed-upon terms, while purchasers are guaranteed that their products or services will be supplied as agreed.
• Risk Mitigation: LCs mitigate the danger of non-payment or non-delivery, both of which are common in trade finance service.
• Financing: LCs could be utilized as collateral to acquire financing for either the buyer or seller.
• Global Trade Facilitation: They facilitate worldwide trade by providing standardized payment and documentation methods.
Disadvantages:
• Fees: Both parties pay fees for the issuing and handling of LCs.
• Complexity: The process requires extensive documentation, which may result in delays and disagreements.
• differences: Even minor differences in documentation can result in nonpayment or litigation.
• Reliance on Banks: The process is primarily reliant on banks, which causes delays in the event of discrepancies or bank-related concerns.
• Restrictive for Small enterprises: The complexity and price of international trading can be prohibitive for small enterprises.
5 Frequently Asked Questions About Letters of Credit
1. What exactly is a LC (Letter of Credit)? If comes to LC (Letter of Credit) then it is a financial instrument utilised in foreign trade to guarantee payment and delivery of goods/services through the employment of banks as intermediaries.
2. What distinguishes an irrevocable LC from a revocable LC? An irreversible LC cannot be amended or cancelled without the approval of all parties, giving more security. A revocable LC, on the other hand, can be changed or cancelled without the beneficiary's approval, providing less protection.
3. What exactly is a Verified LC? A verified LC involves a second bank, in addition to the originating bank, confirming payment, lowering the danger to the seller, particularly if the issuing bank has a weaker credit rating.
4. What are the benefits of utilising a Letter of Credit? LCs provide security, risk reduction, funding options, and worldwide trade facilitation that is standardised.
5. What are the Drawbacks of Letters of Credit? Costs, complexity, the possibility of disparities, reliance on banks, and potential restrictions for small firms are all disadvantages.
Letters of Credit are an important tool in international trade for reconciling the interests of both parties while negotiating the complexity of cross-border transactions. Knowing different kinds and their advantages and disadvantages enables firms to make better educated decisions, resulting in smoother and more trustworthy trade partnerships.
