A letter of credit is a financial tool that can be very useful in some situations. Find out exactly what it is, what types of letters of credit there are, and how they work.

What Is a Letter of Credit?

When you hear the phrase ‘letter of credit,’ it might be natural to think it refers to a document verifying that you are creditworthy, but that isn’t the case. 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.

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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. 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. In most cases, the importer is the buyer and the exporter is the beneficiary.

There are also other types of letters of credit. 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. While not usually required by law, an issuing bank might be required by court order to only issue confirmed letters of credit if they are in receivership. As you might guess, an unconfirmed letter of credit is guaranteed only by the issuing bank. This is the most common form with regard to confirmation.

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 are also called a usance letter of credit and 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

In addition, the normal risks inherent in transactions, such as non-delivery, shipping less than was ordered, inferior quality merchandise, early or late shipment, or goods being damaged in transit, apply.

A Letter of Credit in Action

Sometimes the best way to understand a concept is to walk through an example, so that’s exactly what we’ll do.

Let’s say that Invented Corporation, which is based in California, agrees to buy component Q-13 from the German company Fiktive Ltd. Fiktive’s chief financial officer (CFO) heard at a recent conference that Invented can sometimes be slow to pay invoices, so she agrees to the sale only if Invented’s bank, First Bank of Rackerby, guarantees the payment by issuing a letter of credit with Fiktive as beneficiary. Invented requests an import/export letter of credit from the bank and the bank agrees to issue the letter of credit with the following features:

  • Fiktive must accept an unconfirmed letter of credit so that First Bank of Rackerby won’t have to find a confirming bank.
  • The letter of credit is un-transferrable.
  • Payment is deferred until 30 days after First Bank of Rackerby has received and verified the required documentation.
  • Required documentation consists of Fiktive’s invoice, a certificate of insurance, a certificate of origin from the German government, and an airway bill from DHL (the selected carrier).
  • First Bank of Rackerby will not issue a red clause, nor will it participate in a back-to-back letter of credit.

Fiktive’s CFO agrees to the bank’s terms but asks that their bank, Bank of Armut, be named as advising bank and that payment be made to them. With all terms agreed on, First Bank of Rackerby issues the letter of credit and Fiktive gets to work manufacturing the Q-13s and preparing them for shipment.

Once the Q-13s are ready for shipment, Fiktive issues an invoice for them, applies for and receives a certificate of origin from the German government, insures the shipment and receives the certificate of insurance, and delivers the Q-13s to DHL and receives the airway bill. They fax all of these documents to First Bank of Rackerby and wait.

After receiving the documents from Fiktive, First Bank of Rackerby makes a few telephone calls and verifies that all of the documents are legitimate. Then they, too, begin waiting.

By the end of the 30-day payment deferral, Invented has received the Q-13s, inspected them, and started installing them in their product. To complete the letter of credit agreement, Bank of Rackerby electronically transmits payment to Bank of Armut. Bank of Armut collects the amount Fiktive owes them for financing the production and shipping of the Q-13s, then deposits the remainder in Fiktive’s account.

There are, of course, a number of legalities that make the process more complicated than it seems in this example, and the use of letters of credit should be advised by a lawyer who is familiar with them, as well as by the issuing bank.

Lesson Summary

A letter of credit is a document issued by a third party, such as a bank, that guarantees payment for goods or services when the seller provides acceptable documentation. There are different types of letters of credit with features that are designed to protect the three standard participants: the beneficiary, the buyer, and the issuing bank. For those involved in international trade, letters of credit are almost indispensable, and they can even be useful in certain domestic transactions, such as buying a new Gulfstream jet or an offshore oil platform, which are things we might all like to do.

Review Notes

A letter of credit transaction involves three standard participants
The three participants in letter of credit transactions

Letter of Credit

Definition Types Risks
Document issued by a third party that guarantees payment for goods or services once the seller provides acceptable documentation Import/export, revocable, irrevocable, confirmed, unconfirmed, transferrable, untransferrable, at sight, deferred, usance, red clause, and back-to-back Fraud, regulatory, legal, force majeure, failure of the issuing of collecting bank, or insolvency of the buyer or beneficiary

Learning Outcomes

After you’ve finished this lesson, you should be able to:

  • Define letter of credit
  • Name the three general participants in a letter of credit
  • Describe the different types of letters of credit
  • List the possible required documentation for letters of credit
  • Discuss the risks of letter of credit transactions
  • Provide an example of a letter of credit in action