Types of Letters of Credit

What Is a Letter of Credit?

A letter of credit is an assurance or guarantee to sellers that they will be paid for a large transaction. Letters of credit are particularly common in international or foreign exchanges. They act as a form of payment insurance from a financial institution or another accredited party to the transaction.

The most common types of letters of credit today are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red clause letters of credit.

Types of Letters of Credit Depending on Needs

Different types of letters of credit exist to accommodate the diverse needs and preferences of buyers and sellers engaged in international trade. Very broadly speaking, here's why there are different types:

• Risk Management: Letters of credit are primarily used to mitigate risks associated with international transactions. Different types of letters offer varying levels of risk protection for both buyers and sellers. For example, irrevocable letters of credit provide a higher level of security for sellers, while revocable letters of credit are less secure but may be preferred by buyers seeking more flexibility. Both the buyer and seller can decide on the appropriate letter based on their risk appetite.
• Flexibility: The different types of letters of credit allow parties to tailor the terms and conditions to suit their specific needs beyond risk as well. For instance, transferable letters of credit are useful when there are multiple parties involved in a transaction. These different types of letters of credit can be used depending on the specific circumstances of the trade to promote efficiency and convenience.
• Cost Considerations: Different types of letters of credit come with varying costs and fees. Buyers and sellers may choose a particular type of letter of credit based on their budget and the level of financial commitment they are willing to undertake. This notion is especially important to note in relation to the level of risk they're willing to take on (i.e. how much are the buyer or seller willing to spend for incrementally more risk protection?).
• Regulatory Requirements: Legal and regulatory frameworks governing international trade may influence the choice of the type of letter of credit. For example, some countries or industries may have specific regulations or standards requiring use of specific letters of credit.

Most Common Types of Letters of Credit

Below are some of the more common types of letters of credit. The list is not meant to be exhaustive.

Irrevocable Letter of Credit

In terms of letters of credit, irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed. It cannot be modified or revoked without the agreement of all parties involved, offering a high level of security for both the buyer and the seller.

Revocable Letter of Credit

Alternatively, a revocable letter of credit allows the issuing bank to modify or cancel the credit without the consent of the beneficiary. Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them.

Confirmed Letter of Credit

A confirmed letter of credit involves the addition of a confirmation by a bank other than the issuing bank, typically the seller's bank. This confirmation serves as a secondary guarantee of payment. This adds an extra layer of security for the seller. The seller can rely not only on the issuing bank's credit but also on the assurance of payment from the confirming bank. This type might be most suitable usually when the beneficiary does not trust the other party's bank.

Unconfirmed Letter of Credit

An unconfirmed letter of credit is only guaranteed by the issuing bank and does not involve confirmation from another bank. While this type of letter may be simpler and less expensive for the buyer, it offers less security for the seller. The seller then has to rely solely on the creditworthiness of the issuing bank which may not be sufficient, especially if the seller is unfamiliar with other the other parties.

Standby Letter of Credit

A standby letters of credit work slightly different than most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange. They are commonly used in various scenarios, including construction projects, international trade, and commercial transactions.

Transferable Letter of Credit

A transferable letter of credit allows the seller to transfer all or part of the credit to another party. This flexibility can be beneficial when the seller is unable to fulfill the entire order themselves or when subcontracting certain aspects of the transaction. Transferable letters of credit streamline the payment process and facilitate complex transactions by allowing multiple parties to be involved, such as a small business supplier or construction subcontractor.

Revolving Letter of Credit

A revolving letter of credit is used for multiple shipments over a specified period, allowing the buyer to make multiple drawdowns up to a predetermined limit. This type of letter is useful for ongoing business relationships where there are frequent transactions between the buyer and the seller. An important part here is to realize each party has an ongoing, familiar relationship meaning there is a certain standard of higher trust involved. Revolving letters of credit simplify the payment process by eliminating the need to open a new credit for each shipment meaning they may be more convenient and efficient.

Red Clause Letter of Credit

Red clause letters of credit include a special clause that allow the seller to receive partial payment in advance of shipment. This advance payment, often referred to as a "red clause advance," can be used by the seller to finance the production or purchase of goods for export. This type of letter of credit can give financial assistance to the seller, particularly in situations where they require funds upfront to fulfill the order. For example, consider scenarios where the seller may need to buy specific, rare, expensive raw materials for production of a custom order.

How a Letter of Credit Works 

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review. 

Before a letter of credit is acquired for any transaction, both parties must clearly communicate with each other before submitting an application. Both parties must review the terms and conditions on the application and be aware of deadlines, including the expiration date of the credit and any time allowance granted between the dispatch and presentation.

Although most letters of credit involve international exchange, they can be used to help facilitate any type of trade. Before agreeing to back a letter of credit, a financial institution is likely to review the applicant's credit history, assets, and liabilities and attempt to find proof that the seller has a legitimate operation. 

The buyer often has an existing relationship with the bank. The bank is, therefore, aware of the party's creditworthiness and general financial status. If the buyer is unable to pay the seller, the bank is responsible for making the full payment. If the buyer has made a portion of the payment, the bank is responsible for paying the remainder.

The Bottom Line

Letters of credit helps establish that payment will be made in a business transaction. The various types of letters of credit include commercial letters of credit, standby letters of credit, revolving letters of credit and much more.