A transferable letter of credit allows an original or first beneficiary on a standby bank assurance of funds to transfer the right of payment to other beneficiaries. This process makes it so the original beneficiary can transfer all or part of their original letter of credit to a third party.
If that still sounds a little confusing, keep reading to learn more about how transferable letters of credit work.
Definition and Example of a Transferable Letter of Credit
When you have a transferable letter of credit, you can transfer the right of payment to one or more third parties.
To better understand how that works, it may be helpful to first understand what a letter of credit is. This type of contractual commitment, often seen in trade finance, protects exporters and importers of goods in the business world. A letter of credit is considered to be a highly secure payment instrument but can be expensive and time-consuming to secure. Typically, letters of credit are a better fit for high-risk situations where a secure payment method is absolutely necessary.
One example of a transferable letter of credit is in the case of exporting and importing goods. Let’s say your business imports expensive parts from another country in order to build its products. Your bank makes a commitment in the form of a standby letter of credit on your behalf and then ensures that payment will be made to the exporter of the expensive parts.
In this example, the exporter is the third party and can receive the transferable letter of credit as long as all terms and conditions outlined in the letter of credit are met and verified with proper documentation. The exporter may also need to work with its bank to ensure that it’s satisfied with your bank’s creditworthiness. If the bank approves it, the exporter should receive the letter of credit before it ships the parts. Your bank would then release the payment to the exporter’s bank, and you’d be able to claim the parts at that time.
How a Transferable Letter of Credit Works
When you apply for a transferable letter of credit, it needs to be specifically designated as such by the issuing bank. Also specific is the naming of the beneficiary. Some banks only guarantee payment or credit to one beneficiary. However, that one beneficiary may transfer a letter of credit to another, who then becomes the secondary beneficiary.
Once named a beneficiary, the second beneficiary has the same rights as the original. This beneficiary is then allowed to request that the bank transfer part or all of the letter of credit to another beneficiary. Often, the beneficiary will be a middle person who does not own the goods at the time of the letter of credit being issued. Because of this, the beneficiary will likely utilize this letter of credit in order to purchase those goods.
If a letter of credit is issued by a foreign bank, it may be necessary to have it confirmed by a bank in the U.S. This means that you have a U.S. bank (acting as the confirming bank) promising to pay the exporter.
Letters of credit can be irrevocable, which means you may not be able to alter one unless both parties agree to the changes. In some situations, letters of credit can be revocable, allowing either party to unilaterally make changes. Revocable letters of credit bring much more risk for the exporter.
How To Get a Transferable Letter of Credit
Let’s say you are purchasing goods from another company located in another country. The company you’re in business with has agreed to accept a transferable line of credit. You might take the following steps.
To start the process, both the exporter and its bank need to be confident in the creditworthiness of the importer’s bank, in this case, your bank. If they feel ready to proceed, they will complete a sales agreement, and you will apply for a letter of credit with your bank.
Once your bank drafts the letter of credit based on the terms and conditions outlined in the sales agreement, the exporter’s bank will review and approve the letter of credit and send it to the exporter.
The exporter will then ship the goods and submit the required documents to its bank.
The exporter’s bank will review any documents to make sure they are in compliance with the terms and conditions of the letter of credit. If any document errors or discrepancies are discovered, they must be fixed and the documents must be resubmitted. Once these documents are approved, the exporter's bank will submit them to your bank.
The final step of the process is for your bank to release payment to the exporter’s bank and for you to claim the imported goods.
Pros and Cons of a Transferable Letter of Credit
Secure payment instrument
Expensive and time-consuming
Inaccuracies may lead to delays and fees
- Secure payment instrument: Letters of credit are known for being a reliable and secure payment instrument for businesses.
- Expensive and time-consuming: Letters of credit are recommended for use in high-risk situations as there’s a lot of work that goes into obtaining one. They may also be fairly expensive because of bank fees.
- Inaccuracies may lead to delays and fees: It may be necessary to hire a trained professional to prepare the required documents to apply for a transferable letter of credit as they are often prone to errors and discrepancies because of how detailed they are. These errors may lead to payment delays and extra fees
- Transferable letters of credit make it so a business—known as the original beneficiary, and often the importer of goods—can transfer the right of payment to another business—often the exporter of goods.
- The original beneficiary can transfer part or all of the original letter of credit to a third-party beneficiary.
- Because applying for a letter of credit requires so much detailed documentation it can be easy to make mistakes that lead to payment delays and more fees.