This post focuses on some type of letter of credit.
Have you ever had a challenge differentiating between each type of letter of credit? In a recent article, we discussed 5 common payment methods there are in international trade, one of which is the Letter of Credit.
And in the later post, you find what a letter of credit is, why you need the letter of credit in international trade, its usefulness as a financial tool, amongst other important details.
The importance of letters of credit cannot be overemphasized, even though there are certain benefits and drawbacks. Despite these, there is absolutely no shortcut to accepting the importance of the payment method in International Trade.
Table of Contents
Main Type of Letter of Credit
There are several contemporary letters of credit, as follows;
- Commercial letters of credit,
- standby letters of credit,
- revocable letters of credit,
- irrevocable letters of credit,
- revolving letters of credit,
- red clause letters of credit, and
- Back to back letters of credit
Commercial Letters of Credit (CLC)
A commercial letter of credit (CLC) is like others, a document issued by the bank to ensure that a supplier gets paid for goods and services provided. It is an instrument used to foster the relationship between the supplier and the company on payment matters.
When your supplier is not certain that you will pay, and would not offer your company a trade credit insurance agreement, i.e. allowing the purchase of goods without immediate payment – “on credit”), your bank is involved to stand in with a commercial letter of credit to ensure that the supplier gets paid, at an agreed time or date.
This type of letter of credit is necessitated for some obvious reasons like where the supplier does not trust the company on a future payment term.
Your company may also seek the help of the bank where the company is especially new and yet to build enough creditworthiness to guarantee the supplier of the company’s ability to pay.
Another factor is the terms of operation, inside or outside. If outside, then the need to seek a third party such as the bank to provide the CLC.
Standby Letters of Credit (SBLC)
If you call this a loan issuing to the bank customer to settle the supplier, you may be close to being right. In a Standby Letter of Credit, the bank stands on behalf of the bank customer serving as a guarantee for borrowing money.
It is a legal document containing detailed instructions that a specific amount of money is payable to a seller (supplier) if the buyer (customer or company buying) defaults on the agreement.
The document is used as a ‘safety net’ to pay for a shipment of physical goods, more often, in the situation where an unforeseen event prevents your company (the buyer) from fulfilling their parts in the scheduled payments to the supplier.
Revocable Letters of Credit (RLC)
A revocable letter of credit is one that the issuing bank may change before the stated date, particularly if its beneficiary (the company buying) presents any claim to it.
For instance, after initial issuance, your supplier may present a complaint or counterclaim. This will force the bank to issue an endorsement-backed instruction for payment reversal.
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Irrevocable Letters of Credit (ILC)
If you are looking for a letter of credit that can’t be changed by the bank’s customer, then this is an irrevocable type. It is also called a “Transferable Letter of Credit” where it becomes non-transferrable upon issuance.
The reason to present this type lies in the fact that both your company and the supplier know what they are getting into for sure. After issuance, no one dares mess up with its conditions because it would be binding on both parties involved.
Revolving Letters of Credit (RLC)
A revolving letter of credit allows its beneficiary (your company buying goods or services) to withdraw or borrow different amounts of money up to the total amount available. You can say that it is like a pre-approved loan.
This type of letter of credit is not very common these days because its beneficiary (your company) has the liberty to withdraw the cash at any time. As such, you lose control of how much your suppliers are paid for providing goods and services to you
Back To Back Letter Of Credit
A back-to-back letter of credit or simply put, “back to back”, is where one bank has issued on behalf of another bank’s customer.
Instead of standing with its customer in terms of payment matters, this bank only acts on the second bank’s customer’s instruction when it comes to issuing a CLC.
The bank that stands on behalf of the second bank’s customer is called the “lead bank” while the second bank’s customer is called the “beneficiary”. The lead bank will issue/confirm a CLC to your supplier.
Your company pays for this LC through another set of instructions issued to your own bank which in turn transfers money to an account designated by the beneficiary’s (second bank) customer.
Red Clause Letters of Credit
The red clause identifies the bank’s right to place a claim on the customer (your company or buying party) for any loss incurred by the bank plus interest and other related costs.
The red clause is often placed into a letter of credit in cases where your supplier insists on being paid under “advance” terms, meaning he gets paid before sending you products or services. This can lead to serious misunderstandings between both parties when it comes to whether you received what you pay for. This is because the bank (described earlier) will only confirm a CLC when it’s satisfied that your company has met all its obligations according to what you’ve negotiated with your supplier.
If something goes wrong, and if your supplier presents any claim, the bank will issue an endorsement-backed instruction for payment reversal to avoid compensating the other party.