Introduction
In international trade, a Letter of Credit (LC) is a vital financial instrument used to mitigate risks associated with cross-border transactions. It acts as a guarantee from the buyer’s bank to the seller that payment will be made on fulfilling specified conditions. Letters of Credit ensure security, trust, and smooth execution of trade deals between parties unfamiliar with each other or operating under different legal and economic systems.
There are several types of Letters of Credit designed to address various needs and risks in international trade. Below is a detailed discussion of the main types of Letters of Credit commonly used in international commerce.
Types of Letters of Credit
1. Revocable Letter of Credit
A revocable LC can be modified or cancelled by the issuing bank at any time without prior notice to the beneficiary (seller). This type provides minimal security to the seller because the buyer can change terms or withdraw the LC before payment.
- Usage: Rarely used in international trade due to its uncertainty.
- Risk: High risk for the beneficiary.
2. Irrevocable Letter of Credit
An irrevocable LC cannot be changed or cancelled without the consent of all parties involved — the issuing bank, the buyer, and the seller. It provides a firm commitment of payment, making it the most commonly used LC in international trade.
- Usage: Preferred by exporters for guaranteed payment.
- Benefit: Provides security and certainty.
3. Confirmed Letter of Credit
A confirmed LC involves an additional guarantee by a second bank (usually in the seller’s country) on top of the issuing bank’s commitment. The confirming bank ensures payment even if the issuing bank or buyer defaults.
- Usage: Used when the seller doubts the creditworthiness of the issuing bank or political/economic stability of the buyer’s country.
- Benefit: Extra layer of security for the seller.
4. Unconfirmed Letter of Credit
An unconfirmed LC only carries the issuing bank’s guarantee. The seller relies solely on the creditworthiness and performance of the issuing bank.
- Usage: When the issuing bank is trusted and the seller is comfortable taking that risk.
- Risk: Less secure compared to a confirmed LC.
5. Sight Letter of Credit
A sight LC requires payment to be made immediately (on sight) once the beneficiary presents the required documents conforming to the LC terms.
- Usage: Most common form; ensures quick payment.
- Benefit: Immediate liquidity for the seller.
6. Usance (Deferred Payment) Letter of Credit
A usance LC allows payment after a specified period (e.g., 30, 60, or 90 days) from the date of presentation of documents or shipment date.
- Usage: Provides credit period to the buyer.
- Benefit: Helps buyer manage cash flows but carries more risk for the seller.
7. Transferable Letter of Credit
A transferable LC allows the beneficiary to transfer all or part of the credit to one or more secondary beneficiaries (usually suppliers or manufacturers).
- Usage: Used by intermediaries or trading companies.
- Benefit: Enables layering of supply chain payments.
8. Back-to-Back Letter of Credit
A back-to-back LC involves two separate LCs — one issued in favor of the intermediary by the buyer, and another issued by the intermediary in favor of the supplier. The second LC is backed by the first.
- Usage: Facilitates trade by intermediaries without using their own funds.
- Benefit: Supports complex trade transactions.
9. Revolving Letter of Credit
A revolving LC allows the credit amount to be renewed automatically after utilization within a specified period, either in terms of amount or number of shipments.
- Usage: Used in ongoing trade relations.
- Benefit: Simplifies multiple transactions without repeated approvals.
10. Standby Letter of Credit
A standby LC serves as a guarantee rather than a payment method. It is invoked only if the buyer fails to fulfill contractual obligations.
- Usage: Acts as a safety net.
- Benefit: Provides assurance without immediate payment obligation.
Conclusion
Letters of Credit play a crucial role in facilitating international trade by managing payment risks and providing assurance to exporters and importers. Choosing the appropriate type of LC depends on factors such as trust between parties, creditworthiness, political risks, and the nature of the transaction.
A clear understanding of these various types helps businesses negotiate better trade terms and safeguards their interests effectively in the global marketplace.
Memory Code Table: “RIC STUB FRB”
| Code | Type of Letter of Credit | Key Feature |
|---|---|---|
| R | Revocable | Can be cancelled anytime |
| I | Irrevocable | Cannot be changed without consent |
| C | Confirmed | Second bank guarantee |
| S | Sight | Payment on presentation |
| T | Transferable | Transfer rights to others |
| U | Usance (Deferred Payment) | Payment after a credit period |
| B | Back-to-Back | Two linked credits |
| F | Revolving | Automatic renewal |
| R | Revolving | Repeatable credit |
| B | Standby | Guarantee, not immediate payment |