Letter of Credit Finance: 10 Types With Detail Explanation

Introduction

The financial relationship between buyer and seller is developed on the foundation of trust. To build a long term business interconnection payment guarantee is essential. 

To make sure the payment transaction smoothly works between parties’ letter of financial credit plays an integral role.

Definition

In international trading, the banks provide a guaranteeing letter that a seller would receive payment from the buyer on time. 

A letter of credit (LC) is a payment mechanism that provides an economic warranty to an exporter of goods from a creditworthy bank.  It is also known as banker commercial credit, letter of undertaking, and documentary credit. 

The bank acts as an underwriter and provides a document of a warranty to the buyer. After the agreement, the buyer must submit the payment on the date which is mutually set by both trading parties.

The seller is free from risk as if the buyer goes bankrupt it would be the responsibility of the bank to pay the amount to the seller as agreed in the letter of credit. In case of any dispute, the buyer can withdraw the capital and settle out the issue later in the legal court. 

10 Types of Letter of Credit

1) Irrevocable LC

This letter of credit cannot be altered or canceled without the permission of the seller. The letter shows the complete liability of the issuer to another party.

2) Revocable LC

The undertaking letter could be modified or canceled by issuing a bank or buyer without taking consent or informing the seller. The bank would not reflect any liability to the seller after the unsettlement of LC.

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3) Transferable LC

In this documentation, the seller allocates part of the letter to the next supplier in the chain. This LC gives an advantage on occasions when the seller is not the only manufacturer of goods and purchases some portion from the other party.

4) Back to Back LC

This LC enables the issuing of the second letter of credit based on the first undertaking document. Two credit letters are provided, first by the bank of the buyer to the mediator and second by the bank of the mediator to the seller. 

5) Confirmed LC

When the undertaking is also confirmed by the seller bank or advising bank it is known as a confirmed letter of credit.

6) Unconfirmed LC

The bank that issues the undertaking document would be responsible for the payment of this LC. 

7) Standby LC

Flexible collaboration opportunity provided to trading parties when the importer fails to payment liabilities to the exporter.

The creditworthy bank gives surety to the selling party that if something gets wrong the exporter will get the payment.

8) Red Clause LC

In this contract advance, partial payment is requested before the goods are shipped to the buyer. This financial transaction is printed in red color on the undertaking document terms & conditions that is why is it name red clause LC.

9) Payment at Sight LC

After the required documentation is submitted the payment is transferred to the exported immediately. The maximum delay allows in this financial submission is not more than 7 working days.

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10) Deferred Payment LC

In this LC agreement, the payment is not transferred to the exported at the documentation submission time. The payment is made to the seller later period as decided in the documentary credit.

LC Advantage for the Sellers & Buyers

  1. The letter of credit contract is extremely customizable. The seller and buyer can decide clauses, terms & conditions as per their requirement with mutual understanding.
  2. The providence of an undertaking letter enables the importer to avoid or reduce repayment.
  3. The buying party cannot refuse to give payment to the seller because of complaints about the good.  
  4. LC minimizes the production risk in case the buyer changes his order or cancels the order.
  5. It helps the trade partners to safely expand the business to the global level.

LC Disadvantage for the Sellers & Buyers

  1. The trading parties are required to pay a fee to the bank for providing LC service which increases the cost of business.
  2. The letter for credit is a time-consuming procedure as it requires a lot of formalities and paperwork.
  3. There is a risk of currency fluctuation is present in the import-export trading.
  4. A letter of credit also has time limitations and there is also a risk of fraud.

Conclusion

The letter of credit finance is a reliable way for the efficient functioning of foreign business trading. This trading process helps the seller & buyer to work securely.

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