What is a Letter of Credit – Definition, Types, and Uses

A Letter of Credit, or LC, is a financial instrument. Banks and similar institutions, such as creditworthy financial service companies, insurance companies etc., issue it as a guarantee payment for goods and services when a seller provides all acceptable documents.

There are three participants in a Letter of Credit – the beneficiary, the applicant, and the issuing bank. The beneficiary is the person/company who would receive payment. The applicant is the buyer of goods and services who needs the LC. Issuing banking is the institution that issues the document. In addition, the beneficiary may also request the advising bank for payment to the beneficiary where he is a client, instead of directly paying.

Letter of Credit is mainly used for international trade, governed by the Uniform Customs and Practice (UCP) for Documentary Credits. However, they may be used for other purposes too.

Types of Letter of Credits

  • Commercial: It is the standard documentary Letter of Credit. 
  • Import/Export: Importers and exporters use it for international trade. 
  • Transferable: It allows the beneficiary to transfer all or one a part payment to another supplier in the same chain. It is common when a beneficiary works as an intermediary for the supplier.
  • Un-Transferable: It does not allow third-party money transfers. The beneficiary remains the only recipient of the fund and it is not possible to use the same LC to pay anyone else. 
  • Revocable: The issuing bank or the buyer can change the LC anytime without intimating the seller/beneficiary. This type of LC is not used as frequently as it does not protect the interest of the beneficiary.
  • Irrevocable: LC that does not allow the bank to make any changes without the prior approval of the beneficiary is an irrevocable Letter of Credit. 
  • Standby: It is designed to ensure payment to the party in case of an unforeseen event. If the beneficiary successfully proves that the promised payment has not beenused, a standby LC becomes valid and payable. Though it does not facilitate the transaction, it ensures payment. 
  • Confirmed: LC wherein the advising bank guarantees payment to the beneficiary. Only irrevocable Letter of Credit is confirmed by such banks. The beneficiary received payment through the advising bank or the issuing bank. 
  • Unconfirmed: Only the issuing bank assures LC and does not need a second bank to guarantee. Most LCs is unconfirmed LC. 
  • Revolving: LC used to make multiple payments instead of issuing letters for each transaction. 
  • Back to Back: LC used in a transaction involving an intermediary – first LC issues by the buyer’s bank to the intermediary and second LC issued by the intermediary’sbank to the seller. 
  • Red Clause: LC that pays the beneficiary partially before the goods are shipped or services completed. This is an advance payment against a written confirmation from the seller and receipt. 
  • Green Clause: It pays advance to sellers not against any written undertaking and receipt, but also with a proof of goods warehousing. 
  • Slight: This LC demands payment on submission of necessary documents. Bank reviews all documents and pays the beneficiary if all conditions are met. 
  • Deferred Payment: The LC ensures payment after a stipulated time frame. The bank reviews documents earlier but pays to the beneficiary only after the time frame passes
  • Direct Pay: The LC allows the issuing bank to make direct payment to the beneficiary and asks buyers to repay the same. The beneficiary has no obligation to interact with the buyer.
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