Documentary Letter of Credit – Types | Trade Samaritan

Documentary Letter of Credit – Types

The fundamental purpose of a Letter of credit is to provide transaction payment security to the beneficiary and documentary performance to the applicant and hence all LCs are fundamentally similar. There are however a few categories of LCs which do have a customized usage.

The documentary letter of credit is an important and a very common method of payment in international trade, primarily because of the security it offers to the exporters, desired transaction related documentation it offers to the importer and the lending or the discounting opportunity it offers to the banks. All Letter of Credits usually have a standardized format with variation on a case to case basis in sections such as documents called for, payment terms, location, parties and dates. Different types of LCs facilitate incremental customization.

Different types of Letter of Credit are as follows:

types of documentary letter of credit

Irrevocable

An irrevocable LC cannot be cancelled or amended without the consent of all parties. It is irrelevant if the buyer changes their mind or even goes out of business. The seller is assured of payment against supply of goods or services provided all terms and conditions of the LC are conformed to. With this type of an LC, the exporter can borrow short term finance from any bank or lending institution at a reasonable rate of interest.

Revocable

Revocable LC can be cancelled or amended by either party without any consent. Beneficiary has meager chances to get a revocable letter of credit discounted. UCPDC states that all LCs issued under the rules will be deemed to be irrevocable hence revocable LCs are no longer in the market.

Revolving

Revolving LC is suitable where a series of identical shipment is to be made, it is possible to raise one LC to cover all of them rather than a separate LC for each shipment, the amount payable is reinstated for the next shipment. Till the upper limit of the LC value is met, bank generally provides an option to the importer applicant to reinstate the LC upon payment or with an amendment. The exporter does not have to go to the bank for sanction of fresh limits every time he gets a new order for executing the same.

Confirmed

Exporter’s interest and insecurity may instigate them to obtain the promise of payment from a bank in their own country, by adding their confirmation to the LC; this is addition to the issuing bank promise. Unconfirmed LC is the one which has not acquired confirmation from other bank.

Transferable

In case of a transferable LC, middleman operates between a manufacturer and an end user; it is possible for an LC to be raised showing the agent as the beneficiary but also allowing the transfer of a percentage of LC to the manufacturer. The difference in the value of both the LCs is agent’s profit and both the agent as well as the manufacturer must meet the conditions of the LC to obtain their payment. The letter of credit must clearly state that it is transferable for it to be considered as such. This is a common financing tactic for middlemen and is common in East Asia.

Deferred payment

Deferred payment under LC is becoming increasing popular where an LC term has been signed but the parties wish to avoid raising a bill of exchange under the LC. This will usually be because the bills attract stamp duty in the issuing country. When correct documents are presented, the bank does not “accept” a bill of exchange but instead gives a ‘letter of undertaking’ advising where the money will be paid.

Standby

Standby type of LC is not very common as importers as standby LC is a combination of a bank guarantee and a documentary credit. Payment is made against a draft, statement or certain other basic documents, documents evidencing shipment of merchandise is usually not called for under this type of LC. Standby LC can be issued under International Standby Practices (ISP98) or Uniform customs and practices for Documentary Credits (UCPDC 600).They are used in two situations

ü  Where the seller is trading on open account but requires some security of payment. They are raised by the buyer as a normal LC but require the issuing bank to make payment to the seller only on presentation of documents evidencing non-payment by the buyer within the open account agreement. This is to say, as long as the buyer continues to pay on time under the open account, the LC will not be drawn on or called upon and will expire without any presentation.

ü  Standby LC can also be used to replace performance bond issued by the buyer and required under most procedures. They have the advantage over normal bonds of being regulated by the UCP 600 rule. They are well known in the U.S. and becoming increasing popular in many other markets.

Back to Back

In back to back LC, one irrevocable LC facilitates the exporter or the beneficiary to obtain another LC as an applicant. Back to back LC is typically used by the agent to hide the identity of the real supplier of the goods or services. First LC can be used as a security to issue another. Such transactions originate when a seller receives a letter of credit covering goods which must be obtained from a third party that in turn requires a letter of credit. The “second” issuing bank looks to the first issuing bank for reimbursement after paying under the second letter of credit.

Letter of credit, be it  revolving, back to back or transferable if issued under UCPDC 600 is always an irrevocable letter of credit, irrevocable has become more of an inherent character of the LC than the type.

Reference

International Chamber of Commerce

 

Comments: