The oldest and most common form of short-term trade finance is the letter of credit also known as a Documentary Credit.
There are many different kinds of Letter of Credits and Letter of Credit structures that might stand behind a straightforward credit line to a client:
This is a standard letter of credit that’s commonly used in international trade, and may also be referred to as a documentary credit. Letters of credit provide security to buyers and sellers: the bank guarantees payment as long as documents are produced by the seller (assuming those documents meet the requirements listed in the letter of credit).
For an overview how letters of credit work, see how letters of credit work.
The same credit can be termed an import or export letter of credit depending on whose perspective is considered. For the importer it is termed an Import LC and for the exporter of goods, an Export LC.
The buyer and the issuing bank are able to manipulate the LC or make corrections without informing or getting permissions from the seller. According to UCP 600, all LCs are irrevocable, hence this type of LC is obsolete.
Any changes (amendment) or cancellation of the LC (except if it is expired) is done by the applicant through the issuing bank. It must be authenticated and approved by the beneficiary. An irrevocable letter of credit is a letter of credit that cannot be changed without authorization from all parties involved. Almost all letters of credit now are irrevocable, because revocable letters of credit simply do not provide the security that most beneficiaries want.
A Letter of Credit is said to be confirmed when a second bank adds its confirmation (or guarantee) to honor a complying presentation at the request or authorization of the issuing bank. Exporters might not trust a bank that issues a letter of credit on behalf of a buyer (because the exporter is not familiar with that bank, for example, and is not sure if payment will ever arrive), so they might require that a bank in their home country confirm the letter.
If the issuing bank fails to pay – and the exporter is able to meet all of the requirements of the letter of credit – the confirming bank will have to pay the exporter (and try to collect from the issuing bank later).
This type does not require the other bank's confirmation.
A revolving letter of credit can be used for multiple payments. If a buyer and seller expect to do business continually, they may prefer not to obtain a new letter of credit for every transaction (or for every step in a series of transactions). This type of letter of credit allows businesses to use a single letter of credit for numerous transactions until the letter expires (typically up to one year).
A restricted letter of credit refers to a letter of credit which restricts negotiation to the bank which the issuing bank has nominated in the credit. Only one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC. In a restricted negotiable letter of credit, the authorization from the issuing bank to pay the beneficiary is restricted to a specific nominated bank.
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.
The exporter has the right to make the credit available to one or more subsequent beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not supply the merchandise, but procures goods from suppliers and arranges them to be sent to the buyer and does not want the buyer and supplier know each other.
In a transferable letter of credit, the first beneficiary (the exporter) may request the paying, accepting or negotiating bank to make the credit available in whole or in part to one or more second beneficiary(ies). The second beneficiary can be an export-manufacturer or an export-trader. The L/C is expressly designated "transferable" by the issuing bank on instructions of the applicant. If the words "transmissible", "assignable", "divisible", and "fractionable" are used, the L/C is not transferable.
The letter of credit that was transferred or made available to the second beneficiary is known as the transferred credit. The bank that makes the transfer is known as the transferring bank.
Unless otherwise agreed between the first and second beneficiary, the first beneficiary (the exporter) must pay the transferring bank charges (including commissions, fees, costs, or expenses) in respect to a letter of credit transfer.
A credit that the seller cannot assign all or part of to another party. In international commerce, all credits are untransferable.
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 buyer to pay the required money after taking the related goods and selling them. A deferred payment letter of credit is obviously a better deal for buyers than for sellers. These are also known as term or usance letters of credit.
A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.
Payment under a sight letter of credit occurs as soon as the beneficiary submits acceptable documents to the appropriate bank.
The bank has a few days to review the documents and ensure that they meet the requirements in the letter of credit. If the documents are compliant, payment is made immediately.
Before sending the products, seller can take the pre-paid part of the money from the bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit is established by the assigner bank, is to gain the attention of the offered bank. The terms and conditions were typically written in red ink, thus the name.
With a red clause, the beneficiary has access to cash up front. The buyer allows for an unsecured loan to be issued as part of the letter of credit, which is essentially an advance on the rest of the payment. The seller or beneficiary can then use the money to buy, manufacture, or ship goods to the buyer.
A pair of Letter of Credits in which one is to the benefit of a seller who is not able to provide the corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate companies such as trading houses are sometimes required to open LCs for a supplier and receive Export LCs from buyer.
A back to back letter of credit allows intermediaries to connect buyers and sellers. Two letters of credit are used so that each party gets paid individually: an intermediary gets paid by the buyer, and a supplier gets paid by the intermediary. The final buyer and the intermediary use a “master” letter of credit, and the intermediary and supplier use a letter of credit based on the master letter.
Operates like a Commercial Letter of Credit, except that typically it is retained as a "standby" instead of being the intended payment mechanism. This type of letter of credit is different in that it provides payment if something fails to happen. Instead of facilitating a transaction, a standby letter of credit provides compensation when something goes wrong. They are only payable when the payee (or “beneficiary”) proves that they didn’t get what was promised.
Standby letters of credit can be used to ensure that you’ll get paid, and they can be used to ensure that
services will be performed satisfactorily.
There other forms of trade finance, for a more details article please read our "What is trade finance article" or on a brief overview on on what letters of credit are.
All too complicated?
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