Both the regular letter of credit and standby letter of credit are payment instruments used in international trade. However, there are some basic differences in the product which we will discuss in the following post –
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A letter of credit is a promise from the bank that the buyer i.e. importer will fulfill his payment obligation and pay the full invoice amount on time. The role of the issuing bank is to make sure that the buyer pays. In case the buyer is unable to fulfill his obligation, the bank will pay to the seller i.e. the exporter, but the funds come from the buyer.
On the other hand, a standby letter of credit is a secondary payment method where bank guarantees the payment when terms of the letter of credit are fulfilled by the seller. It is a kind of additional safety net for the seller. The buyer may not pay the seller due to multiple reasons such as cash flow crunch, dishonesty, bankruptcy, etc. But as long as the seller meet’s the requirement of a standby letter of credit, the bank will pay.
Features within the Instrument
A letter of credit does not have any specific features that the buyer must adhere to for completion of a transaction. It does have basic requirements such as documentation, packing, etc. But all in all, it’s a plain vanilla payment instrument.
A standby letter of credit may have specific clauses that the buyer must fulfill so he can use this instrument. For example, Mr. Harry who resides in the UK agrees to buy 5000 pairs of socks from Mr. Chang who resides in China. Mr. Chang does not want to take the risk so he asks Mr. Harry to get a standby letter of credit. Mr. Harry obtains a standby letter of credit from HSBC bank and he adds following clauses –
- The material of the socks should be – 80% cotton 20% polyester
- Each pair should be packed in a clear plastic bag having a logo tag
- There can be only 1% defect margin i.e. only one pair of defective socks in a hundred pairs is acceptable
Mr. Chang should fulfill all the above-mentioned performance criteria to be eligible for payment through a standby letter of credit. A regular letter of credit cannot have such performance criteria
The Requirement of Issuing Bank
When issuing a letter of credit the bank checks the buyer’s credibility and credit score. Furthermore, it is usually the case that a buyer asks his banker for a letter of credit, i.e. the buyer is usually dealing with the said bank for a long time. So the letters of credit are usually unsecured.
Conversely, a standby letter of credit creates an obligation for the bank, therefore the bank will require a collateral in the form of security to issue a standby letter of credit.
The letter of credit is a primary instrument of payment, so the goal is to use the letter of credit to complete the transaction.
In contrast, a standby letter of credit is a secondary instrument of payment. If a seller is paid by a standby letter of credit, it means that something went wrong. The goal here for all the parties involved is to avoid using standby letter of payment.
A letter of credit is a short-term instrument, where the expiry is usually 90 days.
A standby letter of credit is a long-term instrument, in which the validity is usually one year or so.
A letter of credit is used to provide security for a transaction such as a sale agreement.
A standby letter of credit is often used to provide security for a long-term obligation such as a long-term construction project.
A letter of credit is usually used in an international transaction where the buyer is the importer and the seller is the exporter.
A standby letter of credit is used in an international transaction but it is also frequently used in domestic transactions as well. Its scope is not limited to any geographical area.
A standby letter of credit is more expensive than a regular letter of credit. While the fees of a regular letter of credit range from 0.75% to 1.50% of the amount covered, a bank may charge anywhere between 1% to 10% to cover the same amount under a standby letter of credit.1,2