In an international transaction, especially one where the buyer and seller have not previously
transacted with each other, there is a higher risk of default. A letter of credit (LC) or documentary credit is a way to reduce this risk. A letter of credit is a written promise by a bank on behalf of the buyer to pay a specified amount in a credit notice provided that the seller complies with the terms and conditions of the credit notice. Terms and conditions may include the presentation of documents to provide evidence of shipment (e.g., bill of lading, packing list, certificate of insurance) among other requirements. The bank in turn provides assurance that funds will be transferred to the seller.
There are four parties involved in a simple letter of credit transaction: the applicant (buyer); the issuing bank (relates to the applicant); the beneficiary (seller); and the advising bank (also known as confirming bank that relates to the beneficiary).
There are many forms of LCs that adapt to the different situations and needs of the buyer or
seller. Below are some of them:
Merchandise Letter of Credit – payment for merchandise is made once certain documents are produced.
Revocable Letter of Credit – the buyer (applicant) has the right to modify or cancel the credit at any time, up to the shipping date, without the consent of the seller (beneficiary)
Irrevocable Letter of Credit – may not be revoked, cancelled, or changed in any way without the approval of the seller or buyer. It constitutes a definite undertaking by the bank.
Transferable Letter of Credit – original seller (beneficiary) can transfer all or part of the proceeds of an existing credit to another party (secondary beneficiary) – typically, the ultimate supplier of the goods. It can be used by middlemen as a financing tool.
Revolving Letter of Credit – renews the amount of credit on some agreed upon pattern. It allows the seller to draw a specified amount over a specified time.
Standby Letter of Credit – form of credit made by the buyer to the seller without the usual documentary requirements at the time of shipping (also called non-performing letter of credit)
Usance Letter of Credit – sets terms and conditions for payment at a specific future date.
Red Clause Letter of Credit – allows a certain amount of money from the advising bank before documents are forwarded and goods are shipped.
Back-to-Back Letter of Credit – irrevocable letter of credit serves as the collateral for another; the advising bank of the first letter of credit becomes the issuing bank of the second letter of credit.
For more guidance regarding LCs, refer to the Uniform Customs and Practice for Documentary Credits (UCP 600) issued by the International Chamber of Commerce (ICC).