A letter of credit (also known as documentary credit) is a document issued by a bank on behalf of an applicant (the buyer/customer) undertaking to make payment to a beneficiary (the seller/vendor) up to a stated amount of money, within a prescribed time limit and against stipulated documents. There are usually two banks involved in a letter of credit operation. The issuing bank is the bank of the buyer and issues the credit; the advising bank usually located in the sellers country receives the L/C.
Parties to Letters of Credit?
Main parties of Letter of Credit transaction are as below:
- Issuing bank,
- Advising bank,
- Confirming bank.
Types of L/C?
Master Letter of Credit: A letter of credit issued by a bank on behalf of an applicant (the buyer/customer) against the total order undertaking to make payment to a beneficiary (the seller/vendor) up to a stated amount of money, within a prescribed time limit and against stipulated documents. This LC is issued by the name of the parent manufacturing company.
Back-to-Back Letter of Credit: The LC which is opened based on the master LC. This is issued for different units like yarn supplier, fabric supplier, dyeing-printing units, trims & accessories supplier etc. They get payments after master LC being matured.
Unconfirmed Letters of Credit: Unconfirmed Letters of Credit can be described as a letter of credit, which has not been guaranteed or confirmed by any bank other than the bank that opened it. In these types of credits, the only bank that undertakes to honor a complying presentation is the issuing bank.
Confirmed Letters of Credit: If a letter of credit’s payment undertaking is guaranteed by a second bank, in addition to the bank originally issuing the credit this kind of credit is called the confirmed letter of credit. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable credits can be confirmed.
Revocable Letters of Credit: Revocable letters of credit give issuer the amendment or cancellation right of the credit any time without prior notice to the beneficiary. Since revocable letters of credit do not provide any protection to the beneficiary, they are not used frequently.
Irrevocable Letters of Credit: Irrevocable Letters of Credit cannot be amended or cancelled without the agreement of the credit parties.
Transferable Letters of Credit: Transferable letter of credit is a documentary credit that is issued with the option to allow a trader to transfer its rights and obligations to the supplier.
Untransferable L/C: A credit that the seller cannot assign all or part of to another party.
Advance Payment (Red Clause) Letters of Credit: Letter of credit that carries a provision (traditionally 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.
Restricted L/C: Only one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC.
Unrestricted L/C: The confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC.
Deferred L/C: A credit that is not paid/assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller. Typically, seller allows the buyer to pay the required money after taking the related goods and selling them.
At Sight L/C: A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.
Standby L/C: Operates like a Commercial Letter of Credit, except that typically it is retained as a “standby” instead of being the intended payment mechanism. Unlike a trade letter of credit, a standby letter of credit is NOT meant to be used for payment. A standby letter of credit is used as a form of “back-up” guarantee (hence the name “standby”) used for a variety of purposes.