Letter of Credit Basics: Definition and Types

Letter of credit is a payment method used in international trade transactions.

The letter of credit is distinguished itself from other payment methods in international trade by its complex structure and detailed rules.

Due to this complex structure, many international trade personnel have facing difficulties in letter of credit transactions.

Starting with today's post, I will be writing articles regarding different aspects of letters of credit. Hoping that my posts will be helping you out in your daily work.

The first article not only explains letter of credit definition but also defines letters of credit types.

Letter of Credit Definition | Letter of Credit Types

What is Letter of Credit?

There are a couple of payment options available in international trade and letter of credit is one of them.

Other payment methods used in international trade are Cash-in-Advance, Cash Against Documents [(CAD) or (Documentary Collections)], Open Account and Bank Payment Obligation.

All payment methods incorporate different risks for each party involved in the transaction.

For example, if you choose Open Account payment method as an exporter, you will have to burden almost all of the non-payment risk by yourself, unless you secure the payment with another guarantee such as export credit insurance.

What makes letter of credit unique is that letter of credit is one of the most balanced payment method in international trade.

Note: Bank Payment Obligation (BPO) has similar functions like letter of credit, but not used widely.

How to Define Letter of Credit

In order to reach the best definition of a letter of credit, we need to look at the letter of credit rules, which is known as UCP.

UCP means "Uniform Customs and Practice for Documentary Credits". It is a set of rules, which is published by ICC Commission on Banking Technique and Practice in regular intervals.

Most recent UCP rules published in year 2007 and known as UCP 600. Let us see how ICC defines a letter of credit under UCP 600 below:

Definition of Letter of Credit:

"Credit (letter of credit) means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation." (UCP 600, article 2)

What is ICC and UCP? What are the impoartance of these two terms.
Types of Letters of Credit

Letters of credit can be classified under two main categories: Commercial letters of credit and standby letters of credit.

Commercial letters ofc redit, standby letters of credit and other letter of credit types.

Commercial Letters of Credit: If you are dealing with export / import businesses, you may, most probably, have encountered with a commercial letter of credit so far.

Commercial letters of credit are used as a primary payment tool in international trade.

Which means that once you satisfy the terms and conditions of the credit, you will receive the payment.

Majority of commercial letters of credit are issued subject to the latest version of UCP (Uniform Customs and Practice for Documentary Credits).

Standby Letters of Credit: Standby letters of credit share fundamental similarities with bank guarantees, because of the fact that they had been created by US banks, as an alternative to bank guarantees.

Under a standby letter of credit, beneficiary would be paid only if the first payment option has not been working.

As an example, assume that you are marble exporter from Italy. Your buyer in US.

Your buyer wants to pay you via open account term, net payment after 60 days of transport document date.

But the transaction amount is considerably high for you and you do not want to make the shipment under open account terms.

If you elect to secure your payment by a standby letter of credit, your buyer have to get it opened from his bank in your favour.

If your buyer would not pay your invoice as agreed, you can apply to the bank to get paid under the standby letter of credit.

Standby letters of credit and commercial letters of credit have separate set of rules.

Generally, standby letters of credit are issued subject to "The International Standby Practices 1998 (ISP 98)".

While, commercial letters of credit are issued subject to UCP (Uniform Customs and Practice for Documentary Credits).

Note: In rare cases, standby letters of credit are also issued subject to UCP.

Other Letter of Credit Types

Revocable Letters of Credit

Revocable means capable of being revoked; able to be cancelled.

Revocable letter of credit is a type of L/C that can be cancelled anytime without getting any approval from the beneficiary.

It is an old fashion, very risky letter of credit type. Current rules do not allow for issuance of a revocable letter of credit.

All credits issued subject to UCP 600 are irrevocable unless otherwise agreed between the parties.

Irrevocable Letters of Credit

Irrevocable means impossible to retract or revoke.

Irrevocable letters of credit cannot be amended or cancelled by the issuing banks without the agreement of the all credit parties. (Beneficiary and confirming bank, if available)

Unconfirmed  irrevocable letters of credit cannot be modified or cancelled by the issuing banks without the written consent of the beneficiary.

Any alteration, which is made by the issuing bank under a confirmed irrevocable letter of credit, needs to be approved by the beneficiary and the confirming bank in order to be effective.

If any alteration is accepted by the beneficiary but rejected by the confirming bank, then beneficiary would use the old version of the credit with confirmation, or else use the amended L/C without confirmation.

Unconfirmed Letters of Credit

Unconfirmed letters of credit carry only issuing banks payment guarantee.

In other words, under unconfirmed letters of credit, the only bank that undertakes to honor a complying presentation is the issuing bank.

Confirmed Letters of Credit

According to UCP 600, confirmation means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honor or negotiate a complying presentation.

If the issuing bank located in a risky country (in terms of both economic, financial and political risks), beneficiary of the letter of credit may demand that the credit is confirmed by a bank that he can trust.

In most cases, confirming banks and beneficiaries are in the same country. But in some cases, confirming banks may be located in a 3rd country.

For example, letters of credit issued by African Banks, such as Ethiopian Banks, Kenyan Banks, are confirmed by banks in Germany, while the beneficiaries are located in other countries such as Turkey, Hungary, Italy etc...

Clean Letters of Credit:

If a letter of credit is payable upon presentation of the bill of exchange (draft), without any supporting documents being required, it is called a clean letter of credit.

Because the beneficiaries of the clean letters of credit can reach the payment effortlessly, without being concerned with the terms and conditions of the L/Cs, these types of letters of credit are used very seldom.

It is suitable for variety commercial situations where no movement of goods is expected.

Direct pay standby letter of credit can be given as an example of a clean letter of credit.

Transferable Letters of Credit

If a middleman, who is acting as a commission agent that facilitates the trade between buyer and seller, exists in a letter of credit transaction, then transferable letter of credit can be used to complete the business.

Under a transferable letter of credit, middleman has the right to transfer the credit whole or in part to the real supplier / suppliers of the goods.

Back-to-Back Letters of Credit

Back to back letter of credit is an alternative to transferable letter of credit and used in triangle trade transactions.

The main difference between a transferable letter of credit and back to back letter of credit is that while there is one L/C exists in transferable letter of credit, there are two separate L/Cs created in back to back letters of credit.

First 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 L/C.

Advance Payment (Red Clause) Letters of Credit

Letter of credit that carries a provision (in old times, when credits issued in paper form, written or typed in red ink) which allows a seller to draw up to a fixed sum from the advising or paying-bank, in advance of the shipment or before presenting the prescribed documents.