A letter of credit is the instrument in which a bank guarantees the payment to the alternative party in case of default by the account holder to the issuing bank.
In other words, it provides a guarantee to the other bank involved in the transaction as well as his client that it assures the full payment to the transaction by its customer, in case of any default the bank or other financial institution will come forward to fulfill all the terms and conditions and will exactly act as a party to the contract.
It can also be concluded in a manner that the rights and responsibilities will automatically transfer in case of default. Whereas standby letter of credit is a guarantee made by the bank to the beneficiary that in case of failure in payment within a stipulated time, the bank will fulfill the arrangement on behalf of its client.
Like any other instrument this also facilitates and ensures the success of international trade among the global community.
The main purpose of both the letter of credit and the standby letter of credit is to minimize the risk of both parties to the agreement. The seller and buyer can make any type of letter of credit as per the comfort of both, the type of letter of credit also depends on strength of the business relationship between the parties.
Both the parties will try their level best to maximum secure the transaction especially when they are new to each other, in situations like this a confirmed letter of credit is the best way to secure the credit risk. The letter of credit may relax the terms and conditions in case there is a longstanding business relationship between the parties.
This will also depend on the amount of the transaction that is the bigger the amount the more security is needed. A standby letter of credit was developed due to the various limitations placed by the US regulatory authorities on banks and other financial institutions.
As already discussed that there are different types of instruments as per the ease of the seller and buyer to the transaction. The different types of letters of credit are commercial, export/import, transferable and non-transferable, confirmed and unconfirmed, revocable and irrevocable, standby, revolving, back to back, etc.
Every type of letter of credit has its own benefits and limitations as per the agreed terms and conditions mentioned by the parties to the contract.
Similarly, a standby letter of credit has also different types of instruments such as A direct pay standby, A performance standby, A bid bond or tender bond standby, an Advance bond standby, financial standby, commercial standby, counter standby, insurance standby.
For example, a financial standby letter of credit is an irrevocable undertaking that is it cannot be revoked before the permission taken from the beneficiary to the contract and it will make 100% payment upon the default of the prime responsible party however in the performance standby letter of credit the 50% payment will be made by the party upon the default of the prime responsible party.
The concluding remarks of the letter of credits are that these are the main carriers to facilitate the trade across the country boundaries. These instruments further enhanced and strengthen the credibility of international transactions.
There are many benefits of these instruments such as the facilitation of international trade, safe expansion of business around the globe, highly customizable, and supplier receives its money upon the fulfillment of all the transactions thus it is completely credited risk-free business transactions.
Two major risks are involved in international trade one can badly affect the seller and the other can badly affect the buyer, and this risk can be managed through such instruments.
The seller is at credit risk means it would be impossible to collect the amount after dispatching the goods ordered by the client this risk can be managed through a letter of credit and in a better way through a confirmed letter of credit.
The buyer to the transaction is at a greater risk that he will receive goods that are different from the goods ordered by the buyer, this risk can be managed by the letter of credit at the sight which means the bank will pay to the supplier after the inspection of all goods and verification of the required documents mentioned in the contract and also ensure whether the goods are as per the stipulated terms of the agreement or not.