Letters of Credit (different types)

Last Updated: Jun 7, 2019

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Letters of credit are important assurances or guarantees to sellers that they will be paid for a large transaction, particularly with international exchanges. It is a document issued by a third party that guarantees payment for goods or services when the seller provides acceptable documentation. Letters of credit are usually issued by banks or other financial institutions, but some creditworthy financial services companies, like insurance companies or mutual funds, might issue letters of credit under certain circumstances. The most common contemporary letters of credit are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit and red clause letters of credit, although there are several others.

1) Commercial letters of credit, sometimes referred to as import/export letters of credit, are prominent in completing international trades. The International Chamber of Commerce published a Uniform Customs and Practice for Documentary Credits (UCP), with which the majority of commercial letters of credit comply.

2) Standby letters of credit work slightly differently from most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove that it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange.

3) Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently, since most beneficiaries do not agree to them, and the UCP has no provision for them.

4) Irrevocable letters of credit are more common than revocable letters of credit. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable Letters of Credit can either be confirmed or unconfirmed. Confirmed letters require that another financial institution guarantees the payment, which is usually the case when the beneficiary does not trust the other party's bank.

5) Revolving letters of credit are designed for multiple uses. They can be used for a series of payments. These are common among individuals or businesses that expect to do business together on an ongoing basis. There is usually an expiration date attached to these letters of credit, often one year.

6) Red clause letters of credit contain an unsecured loan made by the buyer, which acts as an advance on the rest of the contract. Sometimes one party requests a red clause letter of credit to obtain the funding necessary to buy, manufacture or transport the goods involved in the transaction.

7) Green clause letter of credit, the advance is normally paid not only against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires, but also against receipt of an additional document providing proof that the goods to be shipped have been warehoused. 

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review.

A letter of credit generally has three participants:

1) The Beneficiary - person or company who will be paid.

2) The Buyer or applicant of the goods or services. This is the one who needs the letter of credit.

3) The Issuing Bank, the institution issuing the letter of credit. 

Letters of credit are most often used in international trade, where they are governed by the Uniform Customs and Practice for Documentary Credits (or UCP), the rules of the International Chamber of Commerce. However, they can be used in other situations, as we shall see.