A letter of credit (LC) is a document issued by a bank or financial institution that guarantees the payment of a certain amount of money to a seller (beneficiary) upon the presentation of specified documents by the buyer (applicant). It is a common and secure method of payment in international trade, as it reduces the risk of non-payment or fraud for both parties.
Types of Letters of Credit
Revocable vs Irrevocable LCs
A Revocable LCÂ is one that can be modified or cancelled by the issuing bank at any time, without the consent of the beneficiary. This type of LC offers little protection to the seller, as the buyer or the bank can change the terms or revoke the payment at the last minute.
An Irrevocable LCÂ is one that cannot be changed or cancelled by the issuing bank without the agreement of all parties involved, including the beneficiary. This type of LC offers more security to the seller, as the bank is obligated to honor the payment as long as the seller complies with the terms and conditions of the LC.
Confirmed vs Unconfirmed LCs
A Confirmed LCÂ is one that has been guaranteed by a second bank, usually in the seller’s country, in addition to the issuing bank. This means that the seller can claim the payment from either bank, in case the issuing bank fails to pay or becomes insolvent.
An Unconfirmed LCÂ is one that has only been issued by the buyer’s bank, without the involvement of a second bank. This means that the seller can only claim the payment from the issuing bank, and bears the risk of non-payment or insolvency of the buyer’s bank.
Sight vs Usance LCs
A Sight LCÂ is one that requires the issuing bank to pay the beneficiary as soon as the documents are presented and verified, without any delay or grace period. This type of LC is also known as an at sight LC or a demand LC.
A Usance LCÂ is one that allows the issuing bank to pay the beneficiary after a certain period of time, usually 30, 60, or 90 days, from the date of shipment or presentation of documents. This type of LC is also known as a deferred payment LC or a term LC.
Transferable vs Non-Transferable LCs
A Transferable LCÂ is one that allows the beneficiary to transfer all or part of the rights and obligations of the LC to a third party, usually a supplier or a subcontractor. This type of LC is useful for intermediaries or agents who act as middlemen between the buyer and the seller.
A Non-Transferable LCÂ is one that does not allow the beneficiary to transfer the LC to anyone else. This type of LC is suitable for direct transactions between the buyer and the seller.
Standby vs Commercial LCs
A Standby LCÂ is one that serves as a backup or a guarantee in case the buyer fails to fulfill the contractual obligations, such as paying the seller or delivering the goods. This type of LC is not intended to be used as the primary method of payment but rather as a contingency plan.
A Commercial LCÂ is one that is used as the main method of payment for the transaction and is activated upon the completion of the contractual obligations, such as delivering the goods or services. This type of LC is also known as a documentary LC or a trade LC.
Conclusion
Letters of credit are versatile and flexible instruments that can facilitate international trade and reduce the risks of non-payment or fraud. However, they also involve complex procedures and strict requirements that must be followed by all parties. Therefore, it is important to understand the different types of letters of credit and their implications before using them in your business transactions.
