In general, international traders require financial intermediaries such as banks to guarantee payment, and also the delivery of the goods. Moreover, cash advances or trade credits usually develop after both parties involved have developed a trusted relationship. Therefore, the different types Letters of Credit are used to support these relationships
To explain, Letters of Credit (LC’s) are financial instruments, provided by a third party – usually a financial institution such as a bank – which guarantees payment to the seller in the scenario that the buyer is otherwise unable to. In addition, the Letter is dependent on the correct documents being supplied, however they are frequently used.
In addition, Letters of Credit have many variations – each suited to a different situation. To illustrate, we have defined the main letter types below:
Different types of Letter of Credit
Notably, the Letter can be canceled or amended at any time by either the buyer or the issuing bank without any formal notification. What must be remembered, is that in the latest version of the UCP 600, revocable Letters of Credit have been removed for any transaction undertaken within their jurisdiction.
In contrast, unless all three parties (Buyer, Seller, and Third Party) can agree to terms, then the Letter cannot be canceled, amended or reversed unless a
In this case, the Letter of Credit will be granted “confirmed” status once the exporters confirming bank has added it’s obligation to the issuing bank. With this in mind, the obligation will either be in the form of a guarantee or Assurance of Payment.
On the contrary, an Unconfirmed Letter of Credit is only guaranteed by the issuing bank – meaning there is no confirmation from the exporter’s advisory bank. However, this type of confirmation is most common in LC’s, although in areas of economic instability or political uncertainty, payment could be at risk.
In scenarios where the Beneficiary is an intermediary for the real suppliers of goods and services, the payment will need to be transferred to the actual suppliers. In this way, it is transferable to the next supplier in the chain of trade.
On the other hand, an Un-transferrable Letter of Credit, payments are prevented from being transferred to any third parties, as the beneficiary is the recipient.
A Straight LC or ‘Straight Credit’ is defined by the Bank only being allowed to make payment to the beneficiary named in the Letter. In short, they are not permitted to send any payment to any third parties or intermediaries.
Consequently, the named beneficiary must present documents to the paying bank on or before the expiration date, otherwise, the Letter is nulled.
The issuing bank is obligated to pay the beneficiary but also permitted to make payments to any third party nominated by the original beneficiary.
To explain, in the case of a Restricted LC only one nominated bank can be used for negotiation. Therefore, the authorization of the issuing bank to make payment to the beneficiary is restricted to a specific, nominated bank.
In contrast, with an Unrestricted LC the bank is not specified, which means the Letter of Credit can be negotiated through any bank of the beneficiary’s choice.
In this case, payment can be deferred with a Usance Letter of Credit, which gives time for the buyer to inspect or even sell the goods.
Lastly, if the LC is ‘Sight’, it is payable as soon as the documents have been verified and presented to the corresponding bank.
LC’s have many different variations. Likewise, each of these different types of Letters of Credit help protect traders on both sides of a transaction from the many difficulties associated with cross-boarder trade.