Letter of Credit

Letter of Credit
A letter of credit is a document issued by a third party that guarantees

payment for goods or services when the seller provides acceptable
documentation.
Letters of credit are usually issued by banks or other financial institutions, but
some creditworthy financial services companies, like insurance companies or
mutual funds, might issue letters of credit under certain circumstances.
A letter of credit generally has three participants.
First, there is the beneficiary, the person or company who will be paid.
Next, there is the buyer or applicant of the goods or services. This is the one

who needs the letter of credit.
Letter of Credit
Finally, there is the issuing bank, the institution issuing the letter of credit. In
addition, the beneficiary may request payment to an advising bank, which is
a bank where the beneficiary is a client, rather than directly to the
beneficiary. This might be done, for example, if the advising bank financed
the transaction for the beneficiary until payment was received.
Letters of credit are most often used in international trade, where they are
governed by the Uniform Customs and Practice for Documentary Credits (or
UCP), the rules of the International Chamber of Commerce. However, they
can be used in other situations, as we shall see.
Types and Features of Letters of Credit
Most letters of credit are import/export letters of credit, which, as the name implies, are
letters of credit that are used in international trade.
The same letter of credit would be termed an import letter of credit by the importer and an
export letter of credit by the exporter. The importer is the buyer and the exporter is the
beneficiary.
Following are the major types of letters of credit, details as follows:
The revocable letter of credit can be changed at any time by either the buyer or the issuing
bank with no notification to the beneficiary. The most recent version of the UCP, UCP 600, did
away with this form of letter of credit for any transaction under their jurisdiction.
Conversely, the irrevocable letter of credit only allows change or cancellation of the letter of

credit by the issuing bank after application by the buyer and approval by the beneficiary. All
letters of credit governed by the current UCP are irrevocable letters of credit.
A confirmed letter of credit is one where a second bank agrees to pay the letter of
credit at the request of the issuing bank.
A letter of credit may also be a transferrable letter of credit. These are commonly used
when the beneficiary is simply an intermediary for the real supplier of the goods and
services or is one of a group of suppliers. It allows the named beneficiary to present its
own documentation but transfer all or part of the payment to the actual suppliers. As
you might guess, an un-transferrable letter of credit does not allow transfer of
payments to third parties.
A letter of credit may also be at sight, which is payable as soon as the documentation
has been presented and verified, or payment may be deferred.
Deferred letters of credit may be put off until a certain time period has passed or the
buyer has had the opportunity to inspect or even sell the related goods.
A red clause letter of credit allows the beneficiary to receive partial payment
before shipping the products or performing the services. Originally, these
terms were written in red ink, hence the name. In practical use, issuing banks
will rarely offer these terms unless the beneficiary is very creditworthy or an
advising bank agrees to refund the money if the shipment is not made.
Finally, a back-to-back letter of credit is used in a trade involving an

intermediary, such as a trading house. It is actually made up of two letters of
credit, one issued by the buyer's bank to the intermediary and the other
issued by the intermediary's bank to the seller.
Documentation Requirements
In order to receive payment, the beneficiary must present documentation
of completion of their part in the transaction to the issuing bank. The
documents that the issuing bank will accept are specified in the letter of
credit, but may often include:
• Bills of exchange
• Invoices
• Government documents, such as licenses, certificates of origin,
inspection certificates, embassy legalizations, and phytosanitary
certificates
• Shipping and transport documents, such as bills of lading and airway bills
• Insurance policies or certificates, except cover notes
Risks in Letter of Credit Transactions
Letter of credit transactions are not without risks. The risks inherent in these
types of transactions include:
• Fraud risk, in which the payment is obtained through the use of falsified
or forged documents for worthless or nonexistent merchandise
• Regulatory risk, in which government action may prevent completion of
the transaction
• Legal risk, in which legal action prevents completion of the transaction
• Force majeure risk, in which completion of the transaction is prevented by
an external force, such as war or a natural disaster
• Failure of the issuing or collecting bank
• Or insolvency of the buyer or beneficiary

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Letter of Credit

A letter of credit is a document issued by a third party that guarantees

A letter of credit generally has three participants.

First, there is the beneficiary, the person or company who will be paid.

Next, there is the buyer or applicant of the goods or services. This is the one

Following are the major types of letters of credit, details as follows:

Conversely, the irrevocable letter of credit only allows change or cancellation of the letter of

Finally, a back-to-back letter of credit is used in a trade involving an

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