Letter of credit of otherwise called as LOC is a document issued by a bank in favor of a buyer, providing assurance to the seller, that in the undesirable event of failure of payment by the buyer, the bank will pay the seller for the product delivered. Letter of credit is common in the International trading environment, where both the buyers and sellers are from different distant countries, with different legal regulations, and lack of familiarity, where it serves as a solution to the above-mentioned problems.
Letter of credit is a customizable tool. The beneficiary can get the letter of credit paid either in his name or his bank's name. Before the shipping, the seller could also use the letter of credit as a proof of export order and get funds or loan from his local bank. The letter of credit is also transferrable. The seller has room to assign another third-party company or its subsidy or a corporate parent.
In order to issue a letter of credit, the banks usually demand securities in the form of a pledge of asset or cash as a collateral for providing the buyer with a LoC. There is a charge involved for providing the letter of credit by banks and they collect it based on the size and volume of the letter of credit.
Different types of Letter of Credit
Depending upon the purpose and place the letter of credit has different names. The types are discussed as follows:
Import / Export Letter of Credit
It is the LoC used for export import traders of 2 countries as described above.
These are LoC’s where the names of the beneficiary can be transferred. In exports and imports usually, there are many intermediator involved. So the intermediator should be able to transfer the funds to the actual supplier. In this kind of scenarios, the transferable LoC’s are used.
A revocable LoC is a LoC, where it can be revoked by the buyer, or buyers bank without any notification to the beneficiary bank. These types of LoC’s are at high risk for beneficiaries.
In Irrevocable LoC, any changes can be made by the buyer only after the approval of beneficiary
Un Transferable LoC:
In this type of LoC, it is not possible to transfer the beneficiary mentioned by the buyer’s bank. Usually used to avoid frauds in exports and imports.
Standby Letter of Credit was designed to make sure for the payment in case if something unexpected happens. When a beneficiary, claims that he is not paid for the promised amount, then the Standby LC is used to claim the payment. It is just a tool to ensure the payment.
A LoC assured by the issuing bank alone and it usually doesn’t require a guarantee by the 2nd bank. It is the widely used LoC.
A LoC, where an advising bank guarantees the beneficiary for payment. Usually, the irrevocable LoC are approved by the advising bank. Now the beneficiary has 2 obligations to pay – one is from the advising bank and the other from the issuer bank.
Commercial Letter of Credit
It is called as the standard letter of credit or the commercial LoC.
Red Clause LoC
With this LoC, a partial amount is paid for the beneficiary before the actual goods to be shipped or the service to be delivered, by accepting a receipt as proof from the beneficiary.
Green Clause LoC
This LoC provides the supplier with cash when he produces it to the bank and it also requires a proof of warehousing the goods to be shipped