Letters of Credit: What Are The Different Types

In the world of trade finance, letters of credit are a crucial tool for facilitating international transactions. These financial instruments come in various forms, each with its own unique features and benefits. In this blog post, we’ll explore the different types of letters of credit and their key characteristics.

Documentary Letters of Credit (DLC)

Documentary Letters of Credit (DLC) are the most commonly used type of letter of credit in global trade. These can be issued as either revocable or irrevocable:

Revocable Documentary Letters of Credit

• Revocable DLCs can be altered or even canceled by the buyer without any notice to the seller.
• Due to this, they are often unacceptable to the seller.

Irrevocable Documentary Letters of Credit

• Irrevocable DLCs cannot be altered or canceled by the buyer.
• As long as the seller complies with the terms and conditions, the buyer’s issuing bank must make payment.
• Any alterations to the Irrevocable DLC must be approved by both parties.

Confirmed or Unconfirmed Documentary Letters of Credit

Irrevocable DLCs can be issued as confirmed or unconfirmed, each with its own advantages and disadvantages:

Unconfirmed Documentary Letters of Credit

• The buyer’s issuing bank is the only party responsible for guaranteeing payment to the seller.
• The advising bank acts as a middleman, making payment to the seller only after receiving payment from the issuing bank.

Confirmed Documentary Letters of Credit

• Both the advising bank and issuing bank guarantee payment to the seller.
• The advising bank reviews and confirms that all documentary requirements are met before paying the seller.
• Confirmed DLCs are often used in areas with political or social instability, or when the seller is unfamiliar with the issuing bank.

Standby Letters of Credit (SBLC)

Standby Letters of Credit (SBLC) are payment or performance guarantees, often used as a backup or insurance policy if the buyer fails to pay the seller.

• SBLCs allow a customer to establish rapport with a seller by showing they can and will fulfill payment commitments.
• They can be used to guarantee full payment of a contract, loan repayment, or payment for goods delivered by a third party.
• SBLCs are usually less complicated and have fewer documentation requirements than Irrevocable DLCs.

Other Types of Letters of Credit

There are several other specialized types of letters of credit, including:

• Back-to-Back Letters of Credit: Used by import companies to pay the buyer’s end supplier while being the middleman.
• Deferred Payment Letters of Credit: The buyer agrees to pay the issuing bank after a fixed period.
• Red Clause Letters of Credit: Provide the seller with advanced cash from the buyer’s issuing bank before goods are shipped.
• Revolving Letters of Credit: Restored to their original amount as soon as they’ve been used or drawn down.
• Transferable Letters of Credit: Allow the seller/beneficiary to transfer all or part of the proceeds to a second beneficiary.
• Assignment of Proceeds: The beneficiary assigns all or part of the letter of credit to a third party.

Understanding the different types of letters of credit is crucial for businesses engaged in international trade. By choosing the right type of letter of credit, companies can mitigate risks, secure financing, and facilitate smooth transactions.