There are various types of letter of credit (LC) used in the trade transactions. Some of them may be defined 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. Both, domestic as well as international market, trades use the letter of credit to facilitate the payments and the transactions. A bank or a financial institution acts as a third party between the buyer and the seller and assures the payment of funds on the completion of certain obligations.
Table of Contents
- 1 Definition of Letter of Credit
- 2 Types of Letter of Credit
Definition of Letter of Credit
A letter of credit 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 has submitted the required documents. A letter of credit has three important elements – the beneficiary/ seller who is paid the credit, the buyer/ applicant who buys the goods or services and the issuing bank that issues the letter of credit on the buyer’s request. There might be another bank involved as an advising bank that advises the beneficiary.
Types of Letter of Credit
There are various types of letters of credit used in the trade transactions. Some of the letters of credit may be defined by their purpose. The following are the different types of letters of credit:
A standard LC, also called as documentary credit.
The same letter of credit can be called export or import 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.
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 letter of credit allows the beneficiary to provide its own documents but transfer the money further.
A letter of credit that doesn’t allow 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.
A letter of credit that can be altered any time by the issuing bank or the buyer without any notification to the seller/ beneficiary. Such types of letters are not used frequently as the beneficiary is not provided any protection.
A letter of credit that does not allow the issuing bank to make any changes without the approval of all the parties.
A letter of credit that is designed to assure the payment if the buyer does not pay. The seller proves that the promised payment was not made and he has fulfilled all the terms mentioned under SBLC. 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.
Which the seller or exporter acquires guarantee of payment from a confirming bank (also called the second bank). This is primarily done to avoid the risk of non-payment from the first bank.
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 letter of credit 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.
Back to Back LC
A letter of credit which is commonly used in a transaction including an intermediary. 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.
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.
Green Clause LC
A letter of credit that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods.
A letter of credit that demands payment on the submission of the required documents. The bank reviews the documents and pays the beneficiary if the documents meet the conditions of the letter.
Deferred Payment LC
A letter of credit that ensures payment after a certain period of time. 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.
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.
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 one which serves the purpose completely.