Characteristics and Classifications of Letter of Credit

A major advantage of the letter of credit (LC) is that it is highly customizable. Both the parties can agree to the terms and conditions that suit their business needs. Due to this, the characteristics and types of letters of credit have evolved into a wide range over the years. And few of these characteristics are with the dynamic business requirements. Some of these characteristics are:

Commercial Letter of Credit

It is the most basic form of an LC. In a commercial LC, the importer issues the LC with the exporter as the beneficiary. The issuing bank transfers it to the advising bank, which then makes payment to the exporter upon presentation of the necessary documents and proof on meeting the terms and conditions as set out in the purchase document/agreement.

Confirmed Letter of Credit

Although a commercial LC transfers the creditworthiness from the importer to the issuing bank, there is still a chance that even the issuing bank is unable to make the payment. So, the exporter can seek additional protection by getting confirmed LC where the advising bank also ensures the payment. It will add to the cost of doing business for the exporter.

Deferred Payment Letter of Credit

A normal LC requires the payment to the exporter upon submission of the necessary proofs and documents for complying with the shipment terms and conditions. On the other hand, a deferred LC gives some time to the importer after the receipt of the goods or commencing the shipment before he is required to pay the amount. It is beneficial in an established working relationship where the importer can only get funds for payment after he has started selling his goods. This is one kind of credit transaction in the normal course of business. However, secured through a proper LC.

Classification of Letter of Credit

Discounting the Letter of Credit

As per the deferred payment clause, the exporter may need cash before the payment date. In this case, the advising bank can pay the amount on which they agree to the exporter after deducting a discounting fee before the actual payment by the importer. We can also call such an arrangement ‘discounting the letter of credit‘. In this case, the advising bank can pay the amount on which they agree to the exporter after deducting a discounting fee before the actual payment by the importer. And depending upon the relationship and credentials, the payment can even be before the shipment or before the production starts for that order.

Red Clause and Green Clause Letter of Credit

In a red clause letter of credit, the beneficiary can request an advance payment of the agreed-upon amount by presenting the receipt and writing an undertaking that the shipping documents will be delivered on an agreed-upon date. Green clause LC is similar to the red clause LC, with an additional requirement of presenting the proof that the goods that were about to ship were now in the warehouse.

Negotiable Letter of Credit

Negotiability is a common characteristic of an LC. The parties can negotiate and agree to a time and mode of payment which they provide in the terms and conditions.

Transferable Letter of Credit

The LCs can be transferable as well as non-transferable. In the case of transferable LC, as the term suggests, the LC can be transferred multiple times, usually in domestic transactions.

Revocable Letter of Credit

Again there are revocable or irrevocable LCs. One can revoke and modify a revocable letter of credit without any prior consent of all the parties. Similarly, an irrevocable letter of credit can not be revoked by the recipient/seller.

Standby Letter of Credit

The issuing bank will only make the payment when the applicant can not. Issuance of such LCs is for the long term and is usually not transaction-dependent.

Revolving Letter of Credit

There can be multiple withdrawals from the LCs till it reaches the pre-set limit. Such LCs are usually for the long term and are not transaction-dependent.

Mixed Payments Letter of Credit

Such LCs can have multiple payment terms as well as multiple payment modes. For example, 50% of the payments happen on sight. Another 25% of payments occur after 30 days of shipment. And the remaining 25% of payments will happen on receipt of the shipment.

Third-Party Letter of Credit

The applicant issues the LCs for the beneficiary while the third party makes the actual transaction. Basically, transacting parties and the beneficiary can be different in such types of LCs.

Local Letter of Credit

It is of use in domestic trade transactions, where both the buyer and seller are from the same country. The other term for it is the ‘domestic or in-land letter of credit.’



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

3 thoughts on “Characteristics and Classifications of Letter of Credit”

    • Hi Raheema,
      Thanks for presenting your query.
      Revolving LC means arranging for an LC which is used for more than one shipment. Say acquiring an LC of the value of $2,00,000, whereas each shipment is only of value $20,000. This same LC will be used till 10 such shipments. This was a revolving LC with value. It can be based on time as well where the validity of the LC is for a month, 3 months etc. Hope I have made it clear.
      Thanks.

      Reply

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