Letters of Credit

A Letter of Credit (LOC) is a document stating the commitment on the part of a bank to place an agreed upon sum of money at the disposal of a beneficiary on behalf of a client/counterparty under precisely defined conditions. An LOC is issued in order to facilitate a transaction between a buyer and a seller that are unknown to each other and are seeking some sort of performance and payment guarantee from well-known banks.

Advising bank: The bank (usually the seller's bank) receiving a letter of credit from the issuing bank (the buyer's bank) and handling the transaction from the seller's side. This includes validating the letter of credit, reviewing it for internal consistency, forwarding it to the seller, forwarding seller's documentation back to the issuing bank, and, in the case of a confirmed letter of credit, guaranteeing payment to the seller if documents are in order and the terms of the credit are met.

Beneficiary: the individual or company in whose favor a letter of credit is opened.

Drawee: The buyer in a documentary collection.

Types of LOCs

Irrevocable

Revocable

Sight or Term (documentary)

Confirmed

Standby

Transferable

Back to Back

Red Clause

Revolving

Irrevocable credit: A letter of credit that cannot be revoked or amended without prior mutual consent of the seller, the buyer, and all intermediaries. The Issuing Bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the credit. Changes in the credit must be approved by both the buyer and the seller. This is the most common form of credit used in international trade. There are two forms of irrevocable credits:

Unconfirmed credit (the irrevocable credit not confirmed by the advising bank): In an unconfirmed credit the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's bank is obliged to pay only after the payment from the buyer's bank is received. The seller's bank merely acts on behalf of the issuing bank and therefore incurs no risk.

Confirmed credit (the irrevocable, confirmed credit): In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's (issuing) bank. If the buyer's bank fails to make payment, the seller's bank will pay. If a seller is unfamiliar with the buyer's bank issuing the letter of credit, an irrevocable, confirmed credit may be insisted upon. These credits may be used when trade is conducted in a high-risk area where there are fears of war or social, political, or financial instability. Confirmed credits may also be used by the seller to enlist the aid of a local bank to extend financing to help an order be filled. A confirmed credit costs more because the bank has added liability.

Issuing bank: The buyer's bank which establishes a letter of credit in favor of the seller, or beneficiary (the entity to which credits and payments are made, usually the seller/supplier).

Revocable letter of credit: A letter of credit which may be revoked or amended by the issuer (buyer) without prior notice to other parties in the letter of credit process. It is rarely used and are usually unacceptable to the Seller.

Standby Letter of Credit: This credit is basically a payment or performance guarantee used primarily in the United States. They are often called non-performing letters of credit because they are only used as a backup payment if the collection on a primary payment method is past due. Standby letters of credit can be used, for example, to guarantee repayment of loans, fulfillment by subcontractors, and securing the payment for goods delivered by third parties. The beneficiary to a standby letter of credit can draw from it on demand, so the buyer assumes added risk.