A standby Letter of Credit (SBLC) works as an additional guarantee or cover in a trade agreement. It is a form of documentary credit where the bank becomes a guarantor to the seller for the payment.
It differs from a standard letter of credit in the sense that it is used only in case of unwanted circumstances only. If the buyer fails to oblige the trade terms and make the payment, the bank releases funds through an SBLC.
Buyers use the standby letter of credit as a secondary obligation. It can be used additionally with standard commercial LCs. It is useful for both parties to mitigate the financial risks involved in large trade orders. A financial cover can help both parties to negotiate better trade terms as well.
How Does It Work?
A standby Letter of credit works as a standby guarantee to the seller. It doesn’t proceed unless some unwanted incident like a buyer’s default or bankruptcy happens.
The approval of a standby credit is similar to any other documentary credit. The issuing bank appraises the applicant’s creditworthiness. As the standby credit is an additional guarantee to the seller, the bank assumes full responsibility for the payment.
In that sense, if the buyer defaults, the bank has to clear the standby credit. As with other credit facilities, the bank charges a fee in the range of 1-10% of the credit approved for the period of facility.
Although an SBLC is a guaranteed payment, both seller and buyer must oblige to the trade agreement terms. The terms specified in the SBLC must also be fulfilled before the bank releases the credit.
Features of a Standby Letter Of Credit
A Standby Letter of Credit offers flexible trade opportunities to both parties. The buyer issuing an SBLC can attach further covenant or conditions with the trade agreement. Depending on the buyer’s requested features, a standby LC can take several different types.
1) Financial SBLC
It is used to assure the seller of the financial capabilities of the buyer. It can be a useful trust tool in large trade contracts, where the buyer and seller do not know each other.
A financial SBLC is the most commonly used form of secondary guarantees. It mitigates the risk of default for the seller, as large trade agreements carry high financial risks.
2) Performance SBLC
A performance clause secures the buyer’s interests. The buyer can put specific performance terms such as production in standard units, shipping by a certain date, or quality inspection with an SBLC. The bank will only release the SBLC upon fulfillment of the performance clause.
3) Advance Payment SBLC
The buyers can use the Standby Letter of Credit to adjust against the down payments made for the large contracts as well. It reduces the risk for the buyer against the default or non-fulfillment of the seller. They can include part of the full amount of the advance in the SBLC.
4) As Bidding or Tender Bond
It can also work a tender bond, where the buyer cannot withdraw the offer until the tender is finalized.
The issuing bank of an SBLC can attach different terms upon the request of its client. These conditions and the purpose create the different features of the SBLC.
Advantages of Using a Standby Letter Of Credit
A standby letter of credit shifts the financial towards the issuing bank somewhat. The seller assumes more financial security with an SBLC as the bank becomes the guarantor in case the buyer defaults.
In large trade contracts, the sellers look for the creditworthiness of the buyers. A commercial LC also provides similar risk mitigation benefits. Additionally, a Standby LC would further enhance the trust between the two parties and mitigate the financial risks.
A standby letter of credit offers certain benefits to the buyer as well. Both parties in the trade assume certain advantages with an SBLC.
- It secures the seller against the default of the buyer for non-payment.
- The buyer can attach terms and conditions such as a performance clause with an SBLC securing interests.
- The bank is obliged to pay only if the applicant defaults on the payment.
- The buyer can also feel secure as the seller still needs to fulfill the terms specified in the trade and commercial LC as well.
The sellers of large trade orders require certain financial security. The buyers may argue over trade agreement fulfillment, product quality, or delay that results in non-payment.
In such scenarios, if the seller fulfills other conditions specified in the trade contract, can request the release of the SBLC. Many buyers face temporary cash flow problems by the time of actual payments.