Trade Finance — Part 3— Types of Letter of Credit/ Documentary Credit
There are various types of letter of credit issued by the banks in the financial market. These type I have personally divided into 4 types for easy understanding :
A.Payment Terms
1. Sight Credit
📘LC issued as payment at sight allows the bank to make the payment once the documents are presented and the documents are in conformity.
📘So it means here immediately on acceptance of documents by the bank the payment will be released to the beneficiary.
2. Usance Credit
📘This is the opposite of sight , even on documents being in order of presentation, it will be paid only on the date mentioned on the LC.
📘For instance, if payment terms mentioned in the credit document is a 60 days post shipment.
📘Then from the date of the shipment bank will have 60 days to pay to the beneficiary. This is the most commonly used by the traders.
B.Issuance Terms
1.Revocable
📘A revocable LC can be cancelled by the issuing bank at any time for any reason.
📘There is no mention of this type in the ICC rules and rarely it is being used.
📘It is the most unsecured product for the beneficiary to get into.
📘However for the documentary credit to be revocable it has to be mentioned in the credit document accordingly.
📘Personally, I don’t buy on it at all due to its very nature which dilute the purpose of the document and the trade. If you are fine with defaulting by the buyer then why at first place trying to secure it or why you will secure it with terms that say it’s ok even the bank who has confirmed LC doesn’t paying. Doesn’t makes sense, true.
2.Irrevocable
📘By default LC is irrevocable even if it is not mentioned in the credit document.
📘These most secure forms of product for the beneficiary.
📘These type of LC cannot be cancelled by any party by its own mood’s and fancies.
📘It needs beneficiary approval for making any amendments.
C. Security
1. Confirmed
📘It may be a condition of the seller in the contract with buyer to issue only confirmed LC as part of the payment process as they are more secure.
📘It the seller finds the risk of the buyer country or the issuing bank, it can ask for extra security by asking for confirming LC.
📘In case of confirmed LC, 1 more bank is added “advising bank” who now takes the responsibility of the payment to the seller in case issuing bank fails to pay so.
2. Silent
📘Silent confirmation is the case where confirmation is added only upon a request by the exporter. There is no request to add confirmation on the L/C by the L/C issuing bank.
📘This is the confirmation beneficiary gets from the other bank without involving an issuing bank.
📘Issuing bank is not part of this arrangement and nor do they mostly know about this arrangement.
D. Arrangements
1.Revolving
📘If there is a regular transaction between buyer and seller then this type of credit is most preferred.
📘It allows you to take credit up to a certain limit for a certain period. You don’t need to discuss terms of LC again and again on every shipment.
📘It helps to save on time and administrative tasks and speedy disposal of the matter.
📘You can have single/multiple as many shipments as to require here within the limits provided.
📘In normal case even you want to change the amount it requires a lengthy procedure and submission of documents to the last person on the chain and the acceptance. Hence, by having revolving LC you can anytime go for another transaction by cancelling earlier one.
2.Back to back
📘There can be a scenario wherein you are just a middleman, arranger, however, you want to keep it secret.
📘Here you are buyer for one and seller for another. Hence, you will ask your bank to issue an LC being buyer and receive LC issued by the buyer (here you are selling).
📘Very interesting then why not they raise to each other, why me? Because it is you need or your business and you want to protect it by been keeping secrets of the trade for instance, pricing,place of production,etc.
📘In reality, these types, of LC are also used as part of trade barriers rules of the country. For instance, “X” Country says no import from “Y” country, but do you think traders will agree? Hence, they can take the help of 3rd person (business) in “Z” country and ask him/her to import and then sell to “X”. It is a kind of escape rule. Please don’t consider it as a suggestion (ha-ha 😎😉)
3.Standby
📘In international trade transactions, providers of goods, services or performance commonly request a bank guarantee or bond from their client. 📘These instruments provide a means of securing performance or other obligations under the terms of a contract.
📘In these transactions, the bank acts as a guarantor and will pay the beneficiary a specific sum, usually on presentation of a written demand.
📘In return, the bank will require a counter-indemnity from its client for the full amount and any costs.
📘In a similar vein, a standby letter of credit is a type of trade debt guarantee that is only drawn against in the event that the importer defaults in some way — for example, fails to pay for a consignment within an agreed period.
📘A standby L/C includes an expiry date.
📘Standby L/Cs will normally call for a statement of default from the exporter and also evidence of default as part of the payment process.
📘In simple words, it is just like a guarantee, wherein bank’s step in only on non-performance by the party to the contract. Whereas in normal letter of credit it is a payment by the bank on performance by the parties.
4.Transferable
📘It allows the beneficiary to transfer the proceeds of the LC to some other party on written request to be sent to the bank.
📘Please note it is the clause completely call of the beneficiary to keep or not
📘As ideally, it will impact only the beneficiary.
📘It should be noted that a bank is under no obligation to transfer a credit except to the extent and in the manner expressly consented to by that bank.
📘Unless otherwise agreed at the time of transfer, all charges incurred in respect of a transfer must be paid by the beneficiary who requested the transfer.
Creating a right mix of LC suited to your business need is a skill. Once, you know your trade you can choose the most correct model for yourself. You can combine one or more of these forms and prepare a better product for yourself. For instance, you can combine Usance LC being irrevocable, confirmed, revolving and transferable and so on. The choice of product lies on your shoulder to ensure and optimize on the operational, market and Credit risk. By choosing the right type you will ensure secure yourself in times of uncertainty.
Apart from the above LC types, there are many other trade products which are based on the LC documents. Really, Yes! Why, to ease the flow of money in the market and support the trade. Below are a few of them :
1. Loan Against Import : Traders buy a facility with the bank that allow them to use the goods imported without any payment to the bank for the goods imported. It is like a normal short term loan facility, however, tenor here is short due to the nature and purpose of the financing transactions
2. Export Loans : This is sort of discounting on your LC. You can ask the bank to pay you for the LC opened upfront without submitting the documents (before shipment). Again, it is like a normal short term loan facility which is being provided by the bank to the beneficiary. This is known as invoice financing as well.
There are risks of this kind of product like,
(i) the exporter being unable to provide the goods/services stipulated by the L/C;
(ii) the issuing bank failing to honour its commitment to pay the exporter; and
(iii) the importer deciding not to purchase the goods/services backed by the L/C.
Generally, you will find a variety of products in the line of trade finance of these types or similar in nature. The core purpose of all them remains the same, to ensure free flow of the market transactions, keep liquidity, healthy competition and minimize risk of default/fraudulent transactions.
Important Points🔑 :
🎯Documentary credit and letter of credit both means the same. There is no distinction between the two. ICC rules generally term it as a documentary credit.
🎯Credits are separate from the contract on which they may be based
🎯In LC all parties deals only with documents.
🎯It is a means to provide settlement of the trade transactions
Thank you👍✔
Enjoy other reading on the trade finance topic here :
A. Relevance of trade finance in short - Do read https://medium.com/@nilutjain/business-trade-finance-relevance-b901e29649c4
B. Trade Finance — Part 1 Introduction — Simple Mechanism of Letter of credit — Do read
https://medium.com/@nilutjain/trade-finance-part-1-introduction-simple-mechanism-of-letter-of-credit-c30117412632
C Trade Finance — Part 2 — Letter of credit — Uniform Customs and Practice for Documentary Credits (UCP) 600 -Do read
https://medium.com/@nilutjain/trade-finance-part-2-letter-of-credit-uniform-customs-and-practice-for-documentary-credits-beb075693aec
References :
1. ICC — https://iccwbo.org
2. https://iccwbo.org/content/uploads/sites/3/2010/09/ICC-Register-Report_September-2010.pdf
3. https://icc.academy/types-of-documentary-credit-a-comprehensive-guide-2019/
