You will always be at risk when you buy or sell something, especially if the company you are dealing with is unknown to you. Even if you’re working with trusted partners, unexpected circumstances can have real financial implications. There are many ways to reduce your risk.
A letter of credit can be used to facilitate international trade, as well as other types of transactions. A letter credit allows buyers and sellers to reduce risk, guarantee timely payment and have more confidence in the delivery of goods and services. Understanding the different types of letter of credit will help you decide which type to use, and better understand what is.
Commercial Letters of Credit
This letter of credit is commonly used for international trade. This letter of credit is also known as an “import/export credit” or a “documentary loan”. ” 1 The bank is a neutral party that releases funds after all the conditions have been met.
Standby Letters of Credit
A standby letter provides compensation if something goes wrong. Standby Letters of Credit work similarly to commercial letters, but only pay out when the beneficiary can prove they did not receive what they were promised. Standby letters are an insurance policy that guarantees you will get paid and that the services you provide will be satisfactory. These letters can be used in conjunction with transfers of credit.
Confirmed (and unconfirmed), Letters of Credit
A bank may not be trusted by exporters if it issues a credit letter on behalf of the buyer. If the exporter does not know the bank, then the seller might be hesitant to accept the payment. The exporter may require a bank from their own country to confirm the letter. If the issuing institution fails to pay, and the exporter meets all the conditions of the letter of credits, the confirming institution will be required to pay the exporter.
Letters of credit back-to-back
The back-to-back letter of credit is a way for intermediaries to link buyers and sellers. 4 In this somewhat complex strategy, two separate letters of credit are used so that both parties get paid: A supplier and an intermediary. A “master” letter may be used by the final buyer, the intermediary, and the supplier.
Revolving letters of credit
Revolving letters of credit are useful for multiple payments. 5 If the buyer and seller plan to do business again, they might not want to obtain a new one for each transaction (or step of a series of purchases). A revolving letter of credit is useful for multiple payments.
Sight Letters of Credit
If the documents are in good order, the bank must pay immediately. The bank will pay as soon as the beneficiary submits the required documents.
Deferred Payment Letters of Credit
This type of letter credit allows the seller to receive funds after a period of agreed upon time. Deferred payment letters of credit are a much better deal for the buyer than the seller, since it gives the buyer the time to criticize the seller. These letters are also known as “term”, “usance”, or “usage” letters of credit.
Red Clause Letters of Credit
A red clause allows the beneficiary to receive cash in advance. 7 In exchange for the letter of credit being issued, the buyer agrees to an unsecure loan. This is effectively an advance payment. The beneficiary or seller can use the money for a variety of purposes, including buying supplies, manufacturing goods, or completing work. They can also ship the goods to the buyer.
Unrevocable Letters of Credit
8 Most letters of credits are now irrevocable because revocable ones do not offer the level of security that many beneficiaries desire.
FAQs (Frequently Asked Questions)
What are the benefits of using a Letter of Credit?
The risk of a transaction is transferred to the bank, not the buyer or seller. The money is sent to the right place. The parties can also include quality control measures, safeguards or stipulations in the letters of credit.
How can you obtain a letter credit?
You can obtain a letter of credit by contacting a bank representative. Most likely, only banks with dedicated divisions for international trade and commercial activities will offer letters of credit. If your bank does not offer letters of credits, they can likely direct you to an institution who will.
What is the cost of a letter credit?
The cost of a Letter of Credit depends on the issuing bank. The fee is usually a percentage of your transaction. The exact amount will depend on the bank and your credit rating.
When would an exporter be required to forego a letter or credit?
The exporter might be forced to forgo a letter credit if an importer has a better bargaining position and does not want to use one.
