Types of Letter of credit, Read my last blogs, in which I have written about concept of Letter of Credits, By which you can at least understand the mechanism of Letter of Credits, In this blog, we will cover all main types of Letter of Credits, and understand their working, and understand the situations in which they are used. This might be a long blog, I guarantee if you read the whole blog, then you will understand all types of Letter of Credits.
Types of Letter of Credit, How many types of Letters of Credit are there & How do they work? In my last Blog, I explained the mechanism of how Letter of Credits works & how payments are done? See my previous Letter of Credits blogs to understand the mechanism of Letter of Credit.
I will do a quick recap, what happens in an import-export trade is, there is a buyer who ordered some item from abroad, in my last blog, I take the example of someone who imports computer equipment from China. So, he buys in Letter of Credit. So, the buyer will go to his bank and request for LC, and then the opening or issuing bank, opening banks further transfer the LC to the advising bank. So, advising bank checks the authenticity of that & sell it to the seller, as soon as the LC reaches to the seller, they ship the goods to the buyer, And also submit the documents such as, bill of lading, etc. to the nominated bank.
Nominated bank, is basically a nominated bank of issuing bank or we can call it as negotiating bank, These nominated banks & advising banks can be same, As soon as the documents are submitted to the negotiating bank, the beneficiary get their payments, Beneficiary means seller And then negotiating banks after checking the documents send it to the issuing bank, As per Letter of Credit, shipment are done or not. So, in the Bill of Lading details of goods are written, It sends the document back to issuing bank, Then the document is checked by a buyer after getting approval, The issued bank ordered an applicant to release fund, when the applicant pays to an opening bank, then opening bank paid to a negotiating bank, it already paid to the beneficiary in that way, this cycle operates.
This type of Letter of Credit is called a “commercial Letter of Credit”. Meaning of Commercial Letter of Credit, it is one of the most common Letters of Credit. It has few conditions; this is for simple trade purposes. It is generally facilitated by a guideline from an international chamber of commerce (ICC). These guidelines are called Uniform Custom and Practice for Documentary credits, these are conditions for a letter of credits set by ICC, Format of letter of credit is decided according to that, we also called it an import-export Letter of Credit, so here we have done commercial Letter of Credit.
Understand to other types of Letters of Credit, I think you understood this mechanism, Now, what is StandBy Letter of Credit.
Meaning of StandBy Letter of Credit, We have seen that in Normal commercial Letter of Credit, When shipment completes then payment will be made to the beneficiary, But in the case of StandBY, it is converse, In a StandBy LC payment is not made only when shipment is done but, If there is a breach of any contract, then this StandBy LC is opened, E.g. a construction company fails to deliver the project on time, Then StandBy L.C is taken from that company, If the company also fails to pay then StandBy LC is opened. So, it acts like a bank guarantee, LC opened only when conditions are not met or breach of contract, Otherwise in normal cases applicant or deliver of contact made payment. Basically, it is a backup financial arrangement if a company fails to deliver its obligation, then this L.C is opened for StandBy LC, international Standby practices (ISP) guidelines provided by ICC.
Another type of LC is Revocable LC, Meaning of Revocable Letter of Credit, Revocable LC means issuing banks can change or modify the conditions of an LC, or can cancel it, without notifying the beneficiary, in this LC interest of the beneficiary is not secured, there is no guarantee of payment, these are not endorsed by UCP, there is no mention of Revocable LC in the guidelines of ICC, It is not used much as the interest of the seller is not secured; therefore, irrevocable LC is widely used.
Meaning of Irrevocable Letter of Credit, In Irrevocable LC, it neither changed nor be cancelled without the agreement of credit parties, Agreement of opening bank and advising bank is required, Also agreement of applicant and beneficiary essential Irrevocable LC can be changed, only when all parties agree to it otherwise not, According to the UCP guidelines, all LC are irrevocable until unless an agreement, If they do not agree in writing, then LC will be recognized as Irrevocable LC automatically. So, these are Revocable and Irrevocable LC’s.
Next is Unconfirmed LC, Unconfirmed Letter of Credit Meaning. What we have written about in the whole process was about unconfirmed LC, In this the guarantee was fully of issuing bank, So, issuing bank takes the full guarantee that, in the LC Confirmed Letter of Credit, Meaning If buyer does the default then too, the issuing bank will do the whole payment, But many-a-times, the credit rating of issuing bank is very low, Maybe the issuing bank can be small, so the beneficiary/seller may not trust them, Then, you can bring the guarantee of a big bank whose credit rating is good. So, confirmed LC is that where a second bank guarantee is also given, i.e. a big bank the Issuing bank may not be able to make the payment & the buyer also does default, then I will do the payment, for which we take confirmed LC. Generally, this is done when the credit rating of issuing bank is low or it is a small bank, on which the seller may have trust issues, only irrevocable LCs are confirmed, the confirming bank will not take guarantee of revocable bank.
Next is, Transferrable LC Meaning of Transferrable Letter of Credit. In the transferrable LC, the seller can transfer their right to any other party, The whole LC or some portion of it can assign our right to any other party, The beneficiary, can be a part of a big company, Then it can happen that, the LC can assign its rights to the holding company, So this type of LC are called transferrable LC, these are generally used, when the seller Is not the sole manufacturer, Maybe they can take some parts from any other manufacturer, so in that case the portion of LC. They will share their rights with other company too, Or the case that I have discussed, that the seller could be a subsidiary company, then it can assign the right of LC to the holding company. So, this is called the Transferrable letter of credit.
Then comes Back-to-Back LC, Back-to-Back Letter of Credit, Understand it carefully. here is a buyer and a seller, the payments through the LC in buyer’s bank & the advising bank, the seller and the LC reaches here, Then the LC reaches the seller, this is a normal trade, the seller is an export house or a trader, it is not a manufacturing unit, It could be that, it is only trading with you, now in this case, It will require payments, maybe it does not have goods immediately, Then what it will do is, It will go to the seller’s bank & say that it is buying the goods from a different supplier, This is a 3rd party, In which there are 3 parties who are trading, And three banks, which means there are a total 6 parties, So, it will say that it is buying goods from a different supplier, you give it a back to back LC. Take the current LC as a collateral, And give me a different back to back LC, I am writing BTB for back to back, So now the seller’s bank i.e. the advising bank or negotiating bank will assign back to back LC, And pass it to the supplier’s bank, And finally, this back to back LC will reach to the supplier Let’s assume The exporter has sent the goods at $100,000, They are getting it for $70,000 which means they are getting a profit of $30,000, They will say, they are getting the LC of $100,000 here, Then they will say, you give me $70,000 back to back LC, so this is the way BTB works. It is generally used when, the exporter is a trader or an export house, who don’t have its own manufacturing unit In this case, the seller issues the back to back LC to the supplier, and this advising/negotiating bank Of seller will issue Back to Back LC. by keeping the original LC as a collateral, by chance, If the payment is not done due to any reason, then the seller’s bank will recover it from this LC. The amount of back-to-back LC will be lower than the original LC, and the difference is the trader’s profit. As we have seen, this LC will be $100.000, And the Back-to-Back LC will be of $70.000, Because here we have seen the supplier is giving him the goods at $70,000, And he is selling this at $100,000 to the final buyer. So, the remaining $30,000 will be his profit, this is how Back-to-Back LC works.
Now comes the, Red clause LC Red Clause Letter of Credit Meaning It basically is used for advance payment; Buyer gives the normal LC to the issuing bank and then it will go to the nominated bank, Here the payment is not immediate to the seller, Seller says, He wants an advance payment, because he doesn’t have goods immediately, Now, for manufacturing, packing, dispatching, shipping of those goods he will need money, He says, give me an LC for advance payment by which he can get some initial payment. Here, issuing bank will say to the nominated bank to give him the advance payment on their risk, Advance allowed by nominated bank of issuing bank to allow advance, and is called as RED CLAUSE LC.
He gets the payment from here and it is given, when Seller gives a receipt & a written undertaking that he will deliver the documents when he ships it, So, he will deliver these documents and the nominated banks will get their money against these, nominated bank will surely get the money, because the risk here is taken by the issuing bank, this is also called as unsecured credit. This credit risk is of the issuing bank, and here the buyer is not giving any extra collateral, so the issuing bank is taking the risk. Later, the nominated bank adjusts the seller’s advance payment from the final LC payment. this is how Red Clause LC works.
Then comes, Green Clause LC, Green Clause Letter of Credit Means, It provides Advance payment to the seller for pre-shipment finance & storage at export terminal. Here, the normal LC is there, besides this, a Green Clause LC is given here, no new LC is issued, it is added in the common LC, It is written in Green Ink, and is usually used in export of commodities. If a commodity is exported like Iron Ore, Coal, Wheat, Grains, etc. They are stored in the export terminal, then seller ask for an advance payment, Here the advance payment is done till the storage. Basically, this is a type of secured credit in which the seller must submit the receipt & written undertaking with the receipt given from the warehouse, The advance is given after this. This is a type of secure credit, because the goods are sent to the export terminal & the receipt is given to the Nominated bank, the advance has been adjusted by the nominated bank by the final payment according to the green cause LC. This is the Green Cause LC.
Then comes the, Revolving Lc, Revolving Letter of Credit Meaning, It is used when similar transactions will happen over a period of time. Same LC (revolving LC) will be used for all transactions. For example, $100,000 worth of coal has been exported from Australia & is been imported to India for 12 months, The coal is imported from Australia of $100,000/month, for 12 months. Here, we don’t have to open 12 LC, 1 revolving LC will be enough, And according to that $100,000 payment will be done every month. So, Revolving LC can stipulate that $100,000 can be drawn on monthly basis for 12 months.
Next is, Sight LC, In Sight Lc, Sight Letter of Credit Meaning, When LC demands payment, when the documents are submitted, He ship the goods & submit the documents to the nominated bank, He will say that he has submitted the documents, then do my payment immediately because of this. The Nominated bank will verify the documents & will immediately do the payment. In this, the nominated bank does the payment within 7 days, which is good for the seller.
Deferred Payment LC, in this, Meaning of Deferred Payment LC After the verification of documents, a particular time is set, also the payment is not done immediately, the payment will be done after 30 days of shipment date. Basically, this is good for buyer, The buyer has got the goods after 25 days, then he can check and do the payment afterward, the buyer can claim if the seller has sent any defective item. So, Deferred Payment LC is good for Buyers.
I think, I have covered all types of LC, if you want that I should cover any particular LC in detail then inform me reply to the blog & send this to your Friends & Family.
