There are various types of letter of credit (LC) that prevails in trade transactions. In this post, we are classifying them by their purpose. They are Commercial, Export / Import, Transferable and Non-Transferable, Revocable and Irrevocable, Stand-by, Confirmed, and Unconfirmed, Revolving, Back to Back, Red Clause, Green Clause, Sight, Deferred Payment, and Direct Pay LC.
A letter of credit is an important financial tool in trade transactions. Trades use the LC to facilitate payments and transactions in both domestic and international markets. A bank or a financial institution acts as a third party between the buyer and the seller and assures the payment of funds to complete certain obligations. Let us see more about the various types of letters of credit.
- Definition of Letter of Credit
- Types of Letter of Credit
- Inland LC
- Frequently Asked Questions (FAQs)
Definition of Letter of Credit
An LC is a financial document provided by a third party (with no direct interest in the transaction), mostly a bank or a financial institution, that guarantees the payment of funds for goods and services to the seller once the seller submits the required documents. A letter of credit has three important elements – the beneficiary/seller who is the recipient of the LC, the buyer/applicant who buys the goods or services and the issuing bank that issues the LC on the buyer’s request. At times, another bank is involved as an advising bank that advises the beneficiary.
Types of Letter of Credit
There are various types of letter of credit in trade transactions. Some of these are classified by their purpose. The following are the different types of letters of credit:
A standard LC is also called a documentary credit. For more information, click on Commercial LC.
The same LC becomes an export or import LC depending on who uses it. The exporter will term it as an exporter letter of credit whereas an importer will term it as an importer letter of credit. For more information click on Export/Import LC
A letter of credit that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such LC allows the beneficiary to provide its own documents but transfer the money further. For more information click on Transferable LC.
A letter of credit that doesn’t allow the transfer of money to any third parties. The beneficiary is the only recipient of the money and cannot further use the letter of credit to pay anyone.
An LC that issuing bank or the buyer can alter at any time without any notification to the seller/beneficiary. Such types of letters are not in use frequently as the beneficiary is not provided any protection. For more information click on Revocable LC.
An LC that does not allow the issuing bank to make any changes without the approval of all the parties.
A letter of credit that assures the payment if the buyer does not pay. After fulfilling all the terms under SBLC, if the seller proves that the promised payment was not made. In this situation, the bank will pay to the seller. In a nutshell, it does not facilitate a transaction but guarantees the payment. It is quite similar to a bank guarantee. For more information, click on Standby LC.
Which the seller or exporter acquires the guarantee of payment from a confirming bank (also called the second bank). This is primarily to avoid the risk of non-payment from the first bank. For more information, click on Confirmed LC.
A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank. Mostly the letters of credit are an unconfirmed letter of credit.
When a single LC is issued for covering multiple transactions in place of issuing separate LC for each transaction is called revolving LC. They can be further classified into Time Based (Could be Cumulative or Non-Cumulative) and Value-Based. For more information, click on Revolving LC
Back to Back LC
Back to back LC is an LC which commonly involves an intermediary in a transaction. There are two letters of credit, the first issued by the bank of the buyer to the intermediary and the second issued by the bank of an intermediary to the seller. For more information, click on Back to Back LC.
Red Clause LC
A letter of credit that partially pays the beneficiary before the goods are shipped, or the services are performed. The advance is paid against the written confirmation from the seller and the receipt. For more information, click on Red clause LC.
Green Clause LC
An LC that pays advance to the seller is just not against the written undertaking and a receipt, but also a proof of warehousing the goods. For more information, click on Green Clause LC.
A letter of credit that demands payment on submitting the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter. For more information, click on Sight LC.
Deferred Payment LC
An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. It is also known as Usance LC. For more information, click on Deferred payment LC.
Direct Pay LC
A letter of credit where the issuing bank directly pays the beneficiary and then asks the buyer to repay the amount. The beneficiary may not interact with the buyer.
An inland letter of credit is used for transactions in the home country.
As mentioned above, a letter of credit can be of various types depending on its purpose. It is in the interest of both the buyer and the seller, to understand all the different types thoroughly and then pick the one which serves the purpose completely.
Frequently Asked Questions (FAQs)
Types of LC: commercial LC, export/import LC, transferable LC, un-transferable LC, revocable LC, irrevocable lc, standby LC, confirmed LC, unconfirmed LC, revolving LC, back to back LC, red clause LC and green clause LC, sight LC, and deferred payment LC, and direct pay LC
There are four parties in LC- the beneficiary/seller, the buyer/applicant, issuing bank, and the advising bank.
A revolving LC is a single LC that is used for multiple transactions over a long period of time. It helps to avoid issuing separate LC for each transaction. It is used for the regular shipment of the same commodity between the same buyer and the seller.
The sight LC refers to the document that acts as verification for the payment. The payment is issued on the submission of these documents. The bank reviews these documents and pays the beneficiary only if the submitted documents meet the condition of the letter.