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What Is A Letter Of Credit And Types Of Letter Of Credit?

What Is A Letter Of Credit And Types Of Letter Of Credit

In the case of international business or trade, both parties have to face multiple complexities. If we talk about the most important and sensitive matter, then it is payment. Exporter and importer both are worried about payment, and no one wants to face loss. Due to it, both are looking for a perfect payment method by which they can get some security and minimize the level of risk. It can be possible with the selection of the right payment method only, such as - letter credit. Here, we are going to discuss some major factors regarding this particular international payment method.

What is Letter of Credit?

Letter of credit is the most trusted and highly used payment method in the international trades. All international traders are relying on the letter of credit when it comes to making a final business deal. Some people don’t know what actually letter of credit is. Here, we will discuss it first.

Letter of credit is a kind of financial document that is raised by the importer to the bank as a source of assurance regarding payment as per the conditions signed in the contract. In exchange for a letter of credit, the bank provides a guarantee to the exporter regarding final payments. This payment method works with three different parties, such as -

  • Buyer or importer, who buys goods and gets help from the bank by publishing a letter of credit.
  • Seller or exporter, who sells goods and the recipient of a letter of credit as a guaranteed source of payment.
  • Bank, that issues the letter of credit on the request of the buyer or importer.

During the complete transaction, other banks can also appear as the advisory party by which they can suggest to set up some terms and conditions or lookout for something specific for minimizing the risk. Along with all these things, there are several factors dependent on the selection of the type of letter of credit.

Types Of Letter Of Credit

When it comes to using a letter of credit as the option of payment method in consideration of international trade, then there are multiple options that appeared. You can find different types of letters of credit. Here are some.

Documentary Letter Of Credit (At Sight)

A documentary letter of credit is a kind of specific document that is created by the exporter and provided to the importer. It represents different types of commercial documents regarding trade consideration such as -

  • Insurance policy
  • Certificate of origin
  • Certificate of quality analysis
  • Bill of landing
  • Packing list
  • Invoice
  • Bill of exchange
  • Document to the title to goods

When the complete set of all documents is provided by the exporter to the bank, then he/she can receive payments regarding trade transactions.

Releted: 16 Documents Required For Export

Revolving Letter Of Credit

Sometimes, both parties are making trade transactions continuously. In these conditions, the dealing parties do not have to raise or create a new letter of credit again and again. It can increase the documentation and some legal formalities only that can cause a delay in finalizing the business deal.

In these conditions, the interested ones are capable of using the same letter of credit every time whenever a deal takes place between the importer and exporter.

Back To Back Letter Of Credit

In some cases, the exporters do not have enough funds by which they can invest money on buying goods first, and then put it on shipment to export. In these conditions, all exporters are looking for a source by which they can get goods on credit and make payment when they receive from the importer or buyer.

Here, the back to back letter of credit comes in handy. The exporter has to request the opening bank to issue a letter of credit on the name of the manufacturer directly. It helps the exporter in redirecting payment directly from the importer to the manufacturer. Consequently, the exporter gets to succeed in getting goods on credit.

Red Clause and Green Clause Letter Of Credit

Sometimes, the exporters are willing to get advance payments. In these conditions, they have to work on signing the trade agreement with a red clause letter of credit. By having such a letter of credit, the negotiating bank gets the authority to make a final payment in advance. The important thing about this particular letter is that it is printed in red color. If we talk about the green clause letter of credit, then it is used for making some arrangements regarding finance and storage facility for goods at the port.

Revocable Letter Of Credit

The revocable letter of credit has some specific flexibilities. Due to this particular thing, the importer (opener) or importer’s bank (the opening bank) has the authority to withdraw the letter of credit when they want. Along with it, also they are not liable for informing the exporter regarding withdrawal. After the withdrawal of the letter of credit, the surety towards the exporter regarding payment is no more. It is one of the riskiest things for the exporters.

Irrevocable Letter Of Credit

Irrevocable letters of credit function are completely opposite to the revocable ones. Here, the importer or importer’s bank is not capable of withdrawing the letter of credit only with their own consent. In case they want to make such a kind of change in the trade transaction and payment agreement, then they have to inform the exporter first and get permission for it.

If the exporter does not show his or her consent regarding withdrawal, then no one can take any action against it. Here, the interest of the exporter and his or her payment guarantee is fully secured.

Restricted Letter Of Credit

The restricted letter of credit has some specific restrictions when it comes into effect. Here, the importer is capable of restricting the option of the bank to transfer the shipment documents.

Final Words

By paying attention to the mentioned above points, you can get explained details about some major types of letters of credit. There are some other options available as well. You can sign a trade contract with a suitable payment method by taking proper guidance from the business experts only.

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