Different Types of Letters of Credit
A letter of credit is a payment method that smoothes the way for international trade or other transactions. With a letter of credit, buyers and sellers can reduce their risk and ensure timely payment and delivery of goods or services. Learning about different types of letters of credit can help you choose which one to use and understand what you’re working with.
Commercial Letter of Credit
This is a standard letter of credit that’s commonly used in international trade, and may also be referred to as a documentary credit or an import/export letter of credit. A bank acts as a neutral third party to release funds when all the conditions of the agreement have been met.
Standby Letter of Credit
This type of letter of credit is different: It provides payment if something fails to happen. Instead of facilitating a transaction, a standby letter of credit provides compensation when something goes wrong. Standby letters of credit are very similar to commercial letters of credit, but they are only payable when the payee (or “beneficiary”) proves that they didn’t get what was promised. Standby letters of credit are like insurance that you’ll get paid, and they can be used to ensure that services will be performed satisfactorily.
Confirmed (And Unconfirmed) Letters of Credit
When a letter of credit is confirmed, another bank (presumably one that the beneficiary trusts) guarantees that payment will be made. Exporters might not trust a bank that issues a letter of credit on behalf of a buyer (because the exporter is not familiar with that bank, for example, and is not sure if payment will ever arrive), so they might require that a bank in their home country confirm the letter. If the issuing bank fails to pay—and the exporter can meet all of the requirements of the letter of credit—the confirming bank will have to pay the exporter (and try to collect from the issuing bank later).
Back-to-Back Letters of Credit
A back to back letter of credit allows intermediaries to connect buyers and sellers. Two letters of credit are used so that each party gets paid individually: An intermediary gets paid by the buyer, and a supplier gets paid by the intermediary. The final buyer and the intermediary use a “master” letter of credit, and the intermediary and supplier use a letter of credit based on the master letter.
Revolving Letters of Credit
A revolving letter of credit can be used for multiple payments. If a buyer and seller expect to do business continually, they may prefer not to obtain a new letter of credit for every transaction (or for every step in a series of transactions). This type of letter of credit allows businesses to use a single letter of credit for numerous transactions until the letter expires (typically up to one year).
Sight Letter of Credit
Payment under a sight letter of credit occurs as soon as the beneficiary submits acceptable documents to the appropriate bank. The bank has a few days to review the documents and ensure that they meet the requirements in the letter of credit. If the documents are compliant, payment is made immediately.
Deferred Payment Letter of Credit
With this type of letter of credit, payment does not happen immediately after the documents are accepted. Some agreed-to period of time passes before the seller is paid. A deferred payment letter of credit is naturally a better deal for buyers than for sellers. These are also known as term or usance letters of credit.
Red Clause Letter of Credit
With a red clause, the beneficiary has access to cash up front. The buyer allows for an unsecured loan to be issued as part of the letter of credit, which is essentially an advance on the rest of the payment. The seller or beneficiary can then use the money to buy, manufacture, or ship goods to the buyer.
Irrevocable Letter of Credit
An irrevocable letter of credit cannot be changed without authorization from all parties involved. Almost all letters of credit now are irrevocable, because revocable letters of credit simply do not provide the security that most beneficiaries want.