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What Is a Letter of Credit?

How a letter of credit works, types of letters of credit, example of a letter of credit.

• Applying for a Letter of Credit
• Advantages and Disadvantages
• Letter of Credit FAQs

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Letter of Credit: What It Is, Examples, and How One Is Used

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

A letter of credit, or a credit letter, is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility (financial assistance that is essentially a loan).

Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade to protect buyers and sellers.

Key Takeaways

• A letter of credit is a document sent from a bank or financial institution that guarantees that a seller will receive a buyer’s payment on time and for the full amount.
• Letters of credit are often used within the international trade industry.
• There are many different letters of credit, including one called a revolving letter of credit.
• Banks collect a fee for issuing a letter of credit.

Jessica Olah / Investopedia

Buyers of major purchases may need a letter of credit to assure the seller that the payment will be made. A bank issues a letter of credit to guarantee the payment to the seller, essentially assuming the responsibility of ensuring the seller is paid. A buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay before the bank will guarantee the payment to the seller.

Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit.

Because a letter of credit is typically a negotiable instrument , the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable , the beneficiary may assign another entity , such as a corporate parent or a third party, the right to draw.

The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.

How Much a Letter of Credit Costs

Banks usually charge a fee for a letter of credit, which can be a percentage of the total credit they are backing. The cost of a letter of credit will vary by bank and the size of the letter of credit. For example, the bank may charge 0.75% of the amount that it's guaranteeing.

Fees can also depend on the type of letter. In an import-export situation, an unconfirmed letter of credit is less costly. A confirmed letter of credit may have higher fees attached based on the issuing bank's credit strength.

The types of letters of credit include a commercial letter of credit, a revolving letter of credit, a traveler’s letter of credit, a confirmed letter of credit, and a standby letter of credit. International trade will also sometimes use an unsecured— red clause —letter of credit.

Commercial Letter of Credit

This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.

Revolving Letter of Credit

This kind of letter allows a customer to make any number of draws within a certain limit during a specific period. It can be useful if there are frequent merchandise shipments, for example, and you don't want to redraft or edit letters of credit each time.

Traveler’s Letter of Credit

For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.

Confirmed Letter of Credit

A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default . The issuing bank in international transactions typically requests this arrangement.

Standby Letter of Credit

A standby letter of credit provides payment if something does not occur, which is the opposite of how other types of letters of credit are structured. So, instead of facilitating a transaction with funding, a standby letter of credit is like an insurance contract. It protects and compensates one party (the beneficiary) if the other party named in the agreement fails to perform the stated duty or meets certain service level agreements outlined in the letter of credit.

Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East, who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.

Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is especially valuable when a client is located in a potentially unstable economic environment.

How to Apply for a Letter of Credit

Letters of Credit are best prepared by trained professionals, as mistakes in the detailed documents required can lead to payment delays and fees. Due to industry variations and types of letters of credit, each may be approached differently.

Here's an import-export example.

• The importer's bank credit must satisfy the exporter and their bank. The exporter and importer complete a sales agreement.
• Using the sales agreement's terms and conditions, the importer's bank drafts the letter of credit; this letter is sent to the exporter's bank. The exporter's bank reviews the letter of credit and sends it to the exporter after approval.
• The exporter ships the goods as the letter of credit describes. Any required documentation is submitted to the exporter's bank.
• The exporter's bank reviews documentation to ensure letter of credit terms and conditions were met. If approved, the exporter's bank submits documents to the importer's bank.
• The importer's bank sends payment to the exporter's bank. The importer can now claim the goods sent.

Advantages and Disadvantages of a Letter of Credit

Obtaining letters of credit may be necessary in certain situations. However, like anything else related to banking, trade, and business, there are some pros and cons to acknowledge.

Can create security and build mutual trust for buyers and sellers in trade transactions.

Makes it easier to define the specifics of when and how transactions are to be completed between involved parties.

Letters of credit can be personalized with terms that are tailored to the circumstances of each transaction.

Can make the transfer of funds more efficient and streamlined.

Buyers typically bear the costs of obtaining a letter of credit.

Letters of credit may not cover every detail of the transaction, potentially leaving room for error.

Establishing a letter of credit may be tedious or time-consuming for all parties involved.

The terms of a letter of credit may not account for unexpected changes in the political or economic landscape.

How Does a Letter of Credit Work?

Often, in international trade, a letter of credit is used to signify that a payment will be made to the seller on time and in full, as guaranteed by a bank or financial institution. After sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. Among the various types of letters of credit are a revolving letter of credit, a commercial letter of credit, and a confirmed letter of credit.

What Is an Example of a Letter of Credit?

Consider an exporter in an unstable economic climate, where credit may be more difficult to obtain. A bank could offer a buyer a letter of credit, available within two business days, in which the purchase would be guaranteed by the bank's branch. Because the bank and the exporter have an existing relationship, the bank is knowledgeable of the buyer's creditworthiness , assets, and financial status. 

What Is the Difference Between a Commercial Letter of Credit and a Revolving Letter of Credit?

As one of the most common forms of letters of credit, commercial letters of credit are when the bank makes payment directly to the beneficiary or seller. Revolving letters of credit, by contrast, can be used for multiple payments within a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.

When Does Payment Occur With a Letter of Credit?

A letter of credit is like an escrow account in that payment to the beneficiary only happens when the other party performs a specific act or meets other performance criteria spelled out in the letter of credit agreement.

Letters of credit can play an important part in trade transactions. There are different types of letters of credit that may be used, depending on the circumstances. If you need a letter of credit for a business transaction, your current bank may be the best place to begin your search. However, you may need to expand the net to include larger banks if you maintain accounts at a smaller financial institution.

International Trade Administration. " What Is a Letter of Credit? "

International Chamber of Commerce. “ Global Rules .”

Export-Import Bank of the United States. " To Confirm or Not to Confirm (Letters of Credit) ."

Cornell Law School. " 12 CFR § 208.24 - Letters of credit and acceptances. "

USAID. " Letters of Credit and Trade Finance ," p.106.

FDIC. " Off-Balance Sheet Activities ," p.2

Columbia Bank. " Letters of Credit. "

Citi. “ International Trade .”

Citi. “ Products and Services .”

International Trade Administration. " Letter of Credit. "

International Trade Administration. " Trade Finance Guide ," Page 7.

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What Is a Letter of Credit? Everything You Need to Know

Table of Content

Key takeaways.

• Letters of credit provide assurance of payment for sellers and mitigate the risk of non-payment for buyers, fostering trust and reliability in cross-border transactions.
• Understanding letter of credit types and procedures streamlines international transactions, cutting down on disputes and ensuring adherence to terms.
• Businesses can make informed decisions by weighing the pros and cons of letters of credit, optimizing security against associated costs and complexities.

Introduction

Ever wondered how companies manage to buy and sell stuff from each other, even when they’re super far apart? Well, that’s where a thing called a letter of credit comes in handy. Let’s say there’s Company A in one country and Company B in another. Even though they might not know each other well and are miles apart, they still want to do business smoothly. That’s where the letter of credit helps out.

In this blog, we’re going to dive into what exactly letters of credit are all about. We’ll break down how they work and why they’re so important in global trade. By the end, you’ll have a clear understanding of how letters of credit make buying and selling between far-off companies a whole lot easier. So, stick around to learn the ins and outs of this essential tool for international business!

What Is a Letter of Credit?

A letter of credit is a financial document issued by a bank or financial institution on behalf of a buyer, guaranteeing payment to the seller once certain conditions are met. It serves as a guarantee of payment in international trade transactions, providing security to both the buyer and the seller.

Letters of credit play a crucial role in facilitating international trade by mitigating the risk of non-payment for sellers and ensuring that buyers receive the goods or services they have paid for. Let’s delve deeper into the fundamentals of letters of credit.

Types of Letters of Credit

Understanding the different types of letters of credit is essential for businesses engaging in international trade. Let’s explore the various categories in detail to grasp their significance in global transactions.

1. Documentary Credit vs. Standby Letter of Credit

Documentary Credit: Used primarily in international trade transactions, where the issuing bank guarantees payment to the seller upon presentation of specified documents.

Standby Letter of Credit: Used as a backup payment method in case the buyer fails to fulfill their obligations. It serves as a form of financial guarantee to the seller.

2. Irrevocable vs. Revocable Letters of Credit

Irrevocable Letter of Credit: Cannot be altered or canceled without the consent of all parties involved, providing greater assurance to the seller.

Revocable Letter of Credit: Can be modified or canceled by the issuing bank without prior notice to the beneficiary, offering less security.

3. Confirmed vs. Unconfirmed Letters of Credit

Confirmed Letter of Credit: Involves a second bank (confirming bank) adding its guarantee to the letter of credit, enhancing the security for the seller.

Unconfirmed Letter of Credit: Relies solely on the issuing bank’s creditworthiness , without the involvement of a confirming bank.

Each type of letter of credit has its own unique features and benefits, catering to different requirements and risk preferences. By choosing the right type, businesses can effectively manage their international trade transactions and mitigate financial risks.

The Letter of Credit Process

The process of utilizing a letter of credit involves several steps, from its issuance to the final payment to the seller. Here’s the step-by-step guide:

• Issuance: The buyer applies for a letter of credit from their bank, providing details of the transaction and the required documents.
• Issuing bank’s obligation: The issuing bank issues the letter of credit, specifying the terms and conditions, including the documents required for payment.
• Presentation of documents: The seller ships the goods and presents the required documents to the negotiating bank.
• Examination of documents: The negotiating bank examines the documents to ensure they comply with the terms of the letter of credit.
• Payment or acceptance: If the documents are in order, the negotiating bank forwards them to the issuing bank for payment or acceptance.
• Payment to seller: Upon verification of the documents, the issuing bank makes payment to the seller as per the terms of the letter of credit.

The documents required in a letter of credit transaction vary depending on the nature of the goods or services being traded and the terms specified in the letter of credit. Common documents include invoices, bills of lading, certificates of origin, and inspection certificates.

By following the letter of credit process diligently and understanding the roles of the involved parties, businesses can minimize the risk of disputes and payment delays in international transactions. Clear communication and adherence to the agreed-upon terms are key to successful outcomes.

Advantages and Disadvantages

Understanding the advantages and disadvantages of letters of credit is essential for businesses to make informed decisions regarding their use in international trade. Let’s explore the pros and cons in detail to gain a comprehensive understanding of this payment mechanism.

Benefits of using letters of credit:

• Security: Provides assurance of payment for the seller upon compliance with the terms of the letter of credit.
• Risk mitigation: Minimizes the risk of non-payment or default for both parties involved in the transaction.
• International trade facilitation: Facilitates cross-border transactions by providing a trusted payment mechanism.
• Credit enhancement: Improves the creditworthiness of the buyer, allowing them to negotiate better terms with suppliers.

Potential Drawbacks and Risks:

• Cost: Letters of credit involve fees and charges, which can increase the overall cost of the transaction.
• Complexity: The process of obtaining and using letters of credit can be complex, requiring careful documentation and adherence to terms.
• Potential for disputes: Discrepancies in documents or misunderstandings regarding the terms of the letter of credit can lead to disputes and delays.
• Limited flexibility: Letters of credit may restrict the buyer’s flexibility in negotiating payment terms with the seller.

While letters of credit offer significant advantages in terms of security and risk mitigation, businesses should weigh these benefits against the associated costs and complexities. By carefully assessing their specific requirements and risk tolerance, businesses can determine whether letters of credit are the right payment option for their international transactions.

How to Obtain a Letter of Credit

Obtaining a letter of credit is a critical step in facilitating secure international trade transactions. Understanding the procedures and requirements involved can help businesses navigate the process effectively and ensure timely payment to the seller.

Procedures and Requirements

• Application: The buyer submits an application for a letter of credit to their bank, providing details of the transaction, including the amount, terms, and beneficiary.
• Creditworthiness assessment: The bank assesses the buyer’s creditworthiness and may require collateral or a security deposit to issue the letter of credit.
• Documentation: The buyer provides the necessary documentation, such as purchase contracts, invoices, and shipping details, to support the letter of credit application.
• Terms negotiation: The buyer and seller negotiate the terms of the letter of credit, including payment conditions, shipping terms, and required documents.
• Issuance: Once the terms are agreed upon, the bank issues the letter of credit, specifying the conditions under which payment will be made.

Tips for Successful Application

• Clear communication: Maintain open communication with the bank and the seller to ensure all requirements are met and any issues are addressed promptly.
• Thorough documentation: Provide accurate and complete documentation to support the letter of credit application and facilitate smooth processing.
• Understanding terms: Ensure a clear understanding of the terms and conditions specified in the letter of credit to avoid discrepancies or misunderstandings later on.
• Timely follow-up: Follow up with the bank and the seller to track the progress of the letter of credit issuance and address any delays or issues promptly.

Wrapping Up

In summary, letters of credit are indispensable for secure international trade. They offer assurance to sellers and credit enhancement for buyers, mitigating risks across borders. This guide has covered the basics, types, process, and advantages of letters of credit.

By adhering to best practices and staying informed, businesses can leverage letters of credit to navigate global markets confidently. They represent trust and reliability, enabling smoother transactions and fostering growth in the global economy.

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Letters of Credit ("L/Cs") have evolved over nearly three centuries of commerce into an essential tool for banks and their customers in international business transactions, financings and government contracting. This  Update  provides an overview of some of the key legal and practical concepts that are necessary to use this tool effectively.

The FDIC's examiner's handbook defines a letter of credit as "a document issued by a bank on behalf of its customer authorizing a third party to draw drafts on the bank up to a stipulated amount and with specified terms and conditions," and states that an L/C is a bank's "conditional commitment…to provide payment on drafts drawn in accordance with the document terms."

Governing Law

The sources of "law" governing l/cs are:.

Statute : UCC Article 5 applies to  "letters of credit and to certain rights and obligations arising out of transactions involving letters of credit ." UCC Section 5-108(e) provides that an issuing bank " shall observe standard practice of financial institutions that regularly issue letters of credit ."

Practice codes : Derived from two sources: the  UCP600  ( Uniform Customs and Practice for Documentary Credits 2007 Revision , International Chamber of Commerce Publication No. 600) and the  ISP98  (Institute for International Banking Law and Practice Publication 590;  International Standby Practices  (1998)).

Contract law : With some limited exceptions, any provision of Article  5 may  be modified by contract. Thus, if the UCP600 or ISP98 is incorporated into an L/C, it supersedes any contrary provision of Article 5. The exceptions include the "Independence Principle" (discussed below) and certain other rights and obligations of the issuing bank.

Terminology

Certain terms are important to an understanding of the parties' respective rights and obligations, with some of the most basic being:

Issuer  – the bank that issues the L/C and is required to Honor a Draw by the Beneficiary;

Applicant  – the customer for whose account the L/C is issued;

Beneficiary  – the person in whose favor the L/C is issued and who is entitled to Present/Draw and receive payment from the Issuer;

Honor   – performance of the Issuer's undertaking (in the L/C) to make payment; and

Presentation  (also called a  Draw ) – delivery of document(s) to an Issuer for (or to induce) Honor of the L/C.

The Independence Principle

Central to an understanding of L/C law and practice is that an L/C is a  self-contained whole . This is known as the "Independence Principle" based upon language in UCC §5-103, which states that the rights and obligations of an Issuer to a Beneficiary under an L/C are " independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary ."

The Independence Principle protects all parties. The Issuer is protected because, as long as the Presentation requirements in the L/C are strictly complied with, the Issuer must Honor it  without looking into the relationship between the Applicant-customer and the Beneficiary making the Draw . The Applicant and Beneficiary are also both protected because the Issuer's obligations under the L/C are not affected by the relationship between the Applicant-customer and the Issuer itself. Thus, the Applicant may be in default of its obligations to the Issuer, but the Issuer must nevertheless Honor a proper Presentation.

Types of L/Cs

L/Cs fall into two general categories: "commercial/documentary L/Cs" (which are the primary focus of the UCP600) and "everything else," consisting mainly of what are known as " Standby L/Cs " which, themselves, come in several varieties and are covered by the ISP98.

" Commercial/Documentary L/Cs " are typically issued to facilitate specific transactions and to assure payment in trade or commerce (usually international). Generally, Presentation is made when the underlying transaction is consummated. These are referred to as "documentary L/Cs" because a Draw requires  documentary proof  that the underlying transaction has occurred.

For example, an exporter and importer might agree that goods will be paid for at the time of shipment. The exporter won't ship without assurance of getting paid, and the importer won't pay without assurance that the goods have been shipped. Thus, the importer (Applicant) arranges with its Bank (Issuer) for an L/C that gives the exporter (Beneficiary) the right to Draw when the exporter provides the Issuer with an original Bill of Lading proving shipment. Anecdotally, this is partly why documentary L/Cs were conceived – to avoid having the Issuer bank independently verify shipment, which might have involved the banker making a trip to the dock and watching the goods being loaded and the ship sailing off beyond the horizon.

"Consummation" of the underlying transaction –  i.e. , the goods being placed on the ship – is defined by the terms of the L/C, as are the documentation requirements, which are either spelled out in the L/C or incorporated from the UCP600.

" Standby L/Cs ". The ISP98 defines eight types of Standby L/Cs, of which the most common are " Financial Standbys ."

A Financial Standby is an irrevocable guarantee by an Issuer of Applicant's payment or performance in an underlying transaction. The Beneficiary may Draw, and the Issuer must Honor, if its customer (Applicant) does not pay, deliver or perform. Some event, usually a default by Applicant under its contract with Beneficiary, "triggers" the Beneficiary's right to Draw. Although independent proof of the Beneficiary's right to Draw is not required, a Financial Standby is still "documentary" in the sense that the Beneficiary must make the Draw  in writing  and (typically) represent to the Issuer that Applicant has defaulted. Due to the Independence Principle, the Issuer (without verifying the default) must Honor if the Draw complies with the Presentation requirements spelled out or incorporated into the L/C.

Financial Standbys present an Issuer with both a credit benefit and a credit risk. Because Applicant's default under its contract with the Beneficiary is a condition to the Issuer having to Honor the Beneficiary's Draw, the Issuer may  never  have to "fund" (Honor) as long as Applicant doesn't default; BUT, if the Issuer  does  have to fund, it will be on account of a customer who has already defaulted on a (probably material) business obligation.

A " Direct Pay L/C " is a type of Financial Standby. While it is also an Issuer's guarantee of Applicant's payment of a debt or other obligation, the difference is that Applicant's default is not a condition to Draw – all payments are made by Draws on the L/C. Direct Pay L/Cs are useful in cases where the "Beneficiary" is a group of unaffiliated debt holders ( i.e. , holders of publicly-traded bonds) because this payment method provides liquidity and avoids bankruptcy preference claims against debt service payments. Because of the Independence Principle, the Issuer is the primary obligor for payment of debt service; thus, Applicant's default is of no concern to bondholders and bonds backed by an irrevocable Direct Pay L/C are marketed on the strength of the Issuer's credit, not the Applicant's.

Of special note are Standby L/Cs required by governmental entities. Various Wisconsin Statutes and Administrative Rules require or permit a person transacting business with a state agency (obtaining a license or permit, for example) to provide a Standby L/C primarily to demonstrate proof of financial responsibility in cases where the license or permit, for example, creates a potential monetary obligation to the State. Many Wisconsin state agencies' regulations make reference to such L/Cs, but only the Department of Natural Resources and the Department of Transportation have prescribed forms.

Issuer's Risks

An Issuer's most obvious risk is its customer's default: failure to reimburse the Issuer after a Draw has been Honored. The reimbursement obligation can be a requirement to deposit funds with the Issuer immediately upon a Draw, but can also be part of an ongoing credit relationship where Draws are simply treated as "advances" on a term or revolving credit agreement.

Issuer banks also face other risks, such as fraud (a legitimate Beneficiary makes a fraudulent Draw), forgery (impostor Beneficiary makes a Draw) and sovereign, regulatory and legal risks. Regulatory issues created by L/Cs involving lending limits, contingent liabilities, off-balance sheet treatment and regulatory capital requirements also come into play but are beyond the scope of this overview.

Common Problems

Among the more common L/C problems we have seen with our Issuer bank clients are:

Standby L/Cs that incorrectly incorporate provisions of the UCP600 or, less frequently, Commercial/Documentary L/Cs that incorrectly incorporate from the ISP98;

not being aware of automatic renewal and reinstatement provisions, and potential post-expiry obligations;

failing to insist on strict adherence to the Presentation requirements, especially if they are incorporated from the UCP600 or the ISP98;

failing to Honor a proper Draw as an "accommodation" to its customer/Applicant who has informed the bank of a dispute with the Beneficiary; and

poorly-drafted L/Cs that make inappropriate reference to non-documentary issues.

Banks issuing L/Cs to assist customers in export-import transactions, or providing proof of financial responsibility or liquidity/credit support, should be aware that their obligations and rights are often not obvious from simply reading the L/C without being familiar with the underlying laws and practice codes that are summarized in this  Update . As noted above, a carefully-considered and well-drafted L/C protects all parties, including the Issuer.

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Letters of Credit Letters of Credit

Letters of credit.

A Typical Letter of Credit Transaction

• After the exporter and the buyer have agreed on the terms of a sale, the buyer arranges for its bank to open a letter of credit that specifies the documents needed for payment. The buyer determines which documents will be required.
• The buyer’s bank issues (opens) its irrevocable letter of credit and includes all instructions to the seller relating to the shipment.
• The buyer’s bank sends its irrevocable letter of credit to a U.S. bank and requests confirmation. The exporter may request that a particular U.S. bank be the confirming bank, or the foreign bank may select a U.S. correspondent bank.
• The U.S. bank prepares a letter of confirmation to forward to the exporter, along with the irrevocable letter of credit.
• The exporter carefully reviews all conditions in the letter of credit. The exporter’s freight forwarder is contacted to make sure that the shipping date can be met. If the exporter cannot comply with one or more of the conditions, the customer is alerted at once because an amendment may be necessary.
• The exporter arranges with the freight forwarder to deliver the goods to the appropriate port or airport.
• When the goods are loaded aboard the exporting carrier, the freight forwarder completes the necessary documentation.
• The exporter (or the freight forwarder) presents the documents, evidencing full compliance with the letter of credit terms, to the U.S. bank.
• The bank reviews the documents. If they are in order, the documents are sent to the buyer’s bank for review and then transmitted to the buyer.
•  The buyer (or the buyer’s agent) uses the documents to claim the goods.
•  A sight or time draft accompanies the letter of credit. A sight draft is paid on presentation; a time draft is paid within a specified time period.

Tips on Using Letters of Credit

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A Comprehensive Guide to Standby Letters of Credit (2021)

In this extremely comprehensive guide to standby letters of credit (SBLC), we cover:

• What a standby letter of credit is
• Why SBLCs are used more commonly in the USA
• Risks and considerations to be aware of when using standby letters of credit
• An overview of the different types of SBLC available
• The differences between SBLCs and other similar instruments including demand guarantees
• The rules and regulations you need to know about when using standby letters of credit

The guide is written by Glenn Ransier , Technical Advisor, ICC Banking Commission and the Head of Documentary Trade and Standby LCs with Wells Fargo Bank in North America.

Let's get started. (Note this is a long guide, if you'd rather download the PDF version to read later, you can do so here )

What is a Standby Letter of Credit?

The global rule sets which govern standby letters of credit (SBLC) - both the Uniform Customs and Practices current revision 600 (UCP 600) and International Standby Practices current revision (ISP98) - define a SBLC as an “undertaking”.  An undertaking provides the named beneficiary with an “independent” assurance of payment from the undertaking’s issuer (issuers are most often banks).

The obligations of the SBLC or “undertaking” supplement, and are in addition to, any other underlying contract/agreement between the issuer’s client (In SBLC terms, the client is most often referred to as the applicant) and the client’s contract counterparty (In SBLC terms, the counterparty is known as the beneficiary).

When the issuer bears a stronger credit rating, a SBLC is also a credit enhancement tool.   An applicant’s ability to obtain a SBLC from an issuer reflects good faith as the SBLC supports an applicant’s credit quality.

In most cases and depending on the nature of the type of SBLC being issued, a beneficiary is typically only authorized to claim payment from an issuer in situations where the applicant is unable to successfully conclude the underlying contract.

While a SBLC may include a reference to an underlying contract between an applicant and a beneficiary; the issuer’s obligations remain fully independent of any underlying contract to which it may be supporting.

As an independent undertaking, the issuer of the SBLC  has its own obligation to ultimately pay the beneficiary (or another bank which has already paid the beneficiary such as a confirming bank) on receipt of a document/presentation made by, or on behalf of the beneficiary, which comply with the terms and conditions of the SBLC.

However, most SBLCs never receive a drawing, (also known as: claim or demand for payment) and simply expire in accordance with a SBLC’s stated expiry date/period.  This is because most applicants will successfully complete their contractual obligations and as such, the beneficiary will have no reason to demand payment under a SBLC.  Upon a standby letter of credit’s expiry, it will simply cease to exist and be unavailable for drawing and closed by the issuer.

Unless otherwise stated in a SBLC, standby letters of credit are deemed: “irrevocable” meaning they cannot be changed or cancelled prior to its stated expiry date without the agreement of all parties.

Example of a typical process flow for a SBLC SBLC issuance process – direct to beneficiary or utilizing an advising bank

Benefits of using SBLCs

• A bank’s SBLC substitutes and may enhance or replace the creditworthiness of the applicant for that of the issuer of the standby letter of credit.
• SBLC undertakings support/collateralize “any” type of underlying contract, agreement, or obligation between an issuer’s client/applicant and the applicant’s client/counterparty, the beneficiary.
• SBLCs are recognized globally as an effective means of securing cross-border and domestic contracts.

How are SBLCs commonly used?

Banks following BASEL or Dodd-Frank requirements will classify their issued or confirmed SBLCs as supporting either a “financial” or a “performance” obligation. These two classifications are defined as:

• “Financial” SBLCs are issued to back financial obligation or some form of indebtedness, such as loan repayment, and irrevocably obligate the Issuer in the event the Applicant fails to honor their payment obligation.
• “Performance” SBLCs are issued to back a company’s performance related duties. These are contractual, non-financial obligations such as: completing the building of a road or wind farm, etc. and irrevocably obligate the Issuer in the event the Applicant fails to perform as agreed.

Who are the parties involved in a Standby Letter of Credit?

Advising bank –The beneficiary will typically request that a SBLC is sent to a bank in their country or one with which the beneficiary has a relationship. If the beneficiary does not request a specific bank, the issuing bank will either: send the SBLC directly to the beneficiary or choose to send the SBLC to the beneficiary through a bank with which the issuer has a relationship.

If the issuer sends the standby letter of credit through another bank, the bank that receives the SBLC and sends it to the beneficiary will be known as the advising bank. The advising bank is not a party to a SBLC and has no authority to approve or disapprove an amendments terms or obtain drawing rights.

Applicant - (also known as an instructing party or requesting party) – The SBLC applicant enters into a contract with a counterparty. When the contract requires a standby letter of credit to support it, the applicant will make a request, typically to its bank, to issue a SBLC in favour of its contract’s counterparty. In SBLC terms, the counterparty becomes the beneficiary.

In the underlying contract, the applicant and beneficiary terms associated with SBLCs may have very different names: e.g. lender and borrower; buyer or seller; principal and drawer; etc.

It must be noted that a SBLC’s stated applicant may or may not be the issuer’s client. An applicant may receive silent or openly known support to have a standby letter or credit issued. For example, Company AZA may have insufficient credit or collateral to induce an issuer/bank to issue its SBLC. In such a case, it can enlist its parent, a factoring company, etc. to lend support to help Company AZA be named as the applicant in the SBLC.

The parent or other company providing the support may or may not be stated in the SBLC; however, it is considered the client/applicant of the issuer versus the applicant stated in a SBLC. An applicant is not deemed a party to an SBLC. They are the party which requests an issuer to issue its independent SBLC in favour of a beneficiary.

Beneficiary – is the undertaking party who receives all the benefits of a SBLC. They are the only party who may make a drawing; receive payment against the SBLC and/or accept or reject amendments, etc. In the underlying contract, the applicant and beneficiary terms associated with SBLCs may have very different names: e.g. lender and borrower; buyer or seller; principal and drawer; etc.

Confirmer or Confirming Bank –confirmation may only be added at the request of an issuer. When added, a confirmer or confirming bank becomes similar to a second issuing bank because, like the issuer, the confirmer undertakes to honour (or negotiate) or pay a complying document presentation. The confirmer’s undertaking is in addition to the issuers undertaking, but it may be limited in several manners, such as: a) amount; b) expiry; and c) allowable languages documents may be presented in, etc.

Issuer or Issuing Bank or Opening Bank – is the party that issues a separate, irrevocable, independent SBLC on behalf of its applicant client. Because it is independent, a SBLC is separate and distinct from any underlying contract on which it may have been based. Because it is irrevocable, a SBLC cannot be amended until all parties agree to the amendment.

Nominated Bank is the bank/party authorized by the issuer to undertake honour, negotiate or otherwise make a payment in the event it receives a complying document presentation/demand. A confirmer is most often a nominated bank.

A nominated bank which has not confirmed or otherwise committed to pay in some form has no obligation to do so. Unless a confirmer is involved in a SBLC, it rare to see a nominated party as the majority of SBLCs expire and are only available for payment with the issuer.

Why are SBLCs more commonly used in the United States?

Banks in the U.S. historically did not have the corporate power to issue certain types of guarantees but have generally always had the power to issue letters of credit (LC).

It was relatively simple to take conventional commercial LCs and adjust the drawing conditions to call for documents like default certificates and demands for payment, rather than on board negotiable bills of lading, invoices, and other typical shipping and commercial documents. This meant SBLCs could evolve from commercial LCs. It is harder to convert an ordinary, dependent guarantee into an independent undertaking.

Risks and considerations to be aware of when using SBLCs

Applicant considerations: There is a cost associated with SBLC transactions.

An applicant is not a party to an SBLC. The applicant is a party to an underlying contract while the issuer of the standby letter of credit is not. The applicant requests a SBLC to be issued. However, once issued, the issuer must then make its own, independent examination and payment decisions independent of input from the applicant and what the terms of an underlying contract state.

An applicant should have a relationship comfort with the intended SBLC beneficiary because most standby letters of credit are payable against only a draft/bill of exchange and a simple drawing statement. This allows for the possibility for an improper drawing.

Once a SBLC is issued, all parties must agree to any amendment or cancellation request unless the SBLC has expired.

Applicants must align the contract’s terms with the SBLC especially in the area of drawing requirements. Because a standby letter of credit is documentary, an issuer is not concerned with the underlying contract and will make its payment decision solely upon reviewing a beneficiary’s document presentation on its face, against an SBLCs terms, without seeking confirmation of fact(s), action(s) or statement(s) made by the issuer of any document contained in the presentation.

Beneficiary considerations: A beneficiary must determine its credit rating of the issuer. Where an issuer’s credit rating, size or country risks are unacceptable to the beneficiary, a beneficiary may require an acceptable confirming bank.

Once the beneficiary receives a SBLC, it should ensure that SBLC wording complies with the requirements of the underlying contract e.g.

• Can a beneficiary legally make the required statements and are all reasons they can make a demand for payment properly addressed?
• Does the SBLC expire with sufficient time to complete the underlying contract?
• Can the beneficiary obtain all required drawing documents?

This upfront review will help to assure success if the beneficiary makes a drawing against the SBLC, understanding that when a presentation does not comply with a SBLC’s stated terms/conditions, an issuer is not obligated to pay.

The SBLC should be made subject to its preferred international rules such as ISP98 versus UCP600 as the rules align everyone involved with a SBLC and may also assist in the case of a legal matter.

Confirmation and/or advising costs may be due by the beneficiary.

Issuer considerations: As the issuer is supporting its applicant, it needs to consider the applicant’s credit rating. They also need to consider their ability to complete the underlying contract/agreement, often without reviewing the contract/agreement.

Reputational and/or compliance risks such as money laundering, collusion between an applicant and a beneficiary, supporting an unpopular contract/agreement, etc. should also be considered.

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Types of SBLC

Here is an overview of the most common types of SBLC.

Advance payment

This SBLC’s purpose is to ensure the repayment of an advance payment which a buyer has made (or will make at a contract’s closing) to the supplier of goods or services.

In connection with large contracts, especially international transactions, the parties will agree that a supplier of goods or services must receive a certain percentage of the overall contracted value, e.g. 10% upon signing of the contract. To safeguard the buyer against losing its advance payment, they will require an SBLC naming them as the beneficiary to secure the repayment of the sum(s) advanced should the contracted goods or services not be delivered or completed.

The SBLC ensures the buyer is made whole for any advance made. However, often these types of SBLC’s do not provide remuneration for any loss of interest or profit margins that the buyer may sustain.

Bid or tender bond

Supports an issuers' client’s bid to be awarded for a project or contract mandate. This type of SBLC assures the beneficiary that if selected, the applicant has the ability to support and comply with its bid and that they will honour the bid if they are selected. Most often used by contractors or construction companies, they are typically needed for a portion of the overall project’s value.

A SBLC which generally requires only the presentation of a draft or bill of exchange without the need of any supporting statements whatsoever. From an applicant and/or an issuers perspective, these are considered the riskiest type of SBLC. This is because a beneficiary will be able to draw for any reason. It is also risky because the simple terms of the SBLC with regards to a presentation or drawing requirement makes it difficult to stop an improper drawing.

Supports an applicant’s payment obligations to pay for goods or services on a one-off or ongoing basis in the event of non-payment by other methods.

Direct Pay LCs are hybrid SBLCs issued to provide a credit enhancement to a bond offering. E.g. industrial revenue bond, also commonly referred to as variable rate demand bonds. These types of SBLC are most often issued in favour of the bond trustee. Unlike the majority of SBLCs, they are the primary payment mechanism for the interest and principal due on the underlying bond and will receive periodic drawings for payment.

A large majority of SBLCs will fall into this category.  These standby letters of credit will support any financial payment obligation such as loan repayments, etc.

These SBLCs address the insurance or reinsurance obligations of the applicant and are used by insurance companies to distribute insurance risks among themselves. Rather than cash collateralizing other insurers or beneficiaries for use of their internal lines of credit, these SBLC’s are used as collateral.

Performance

A performance SBLC is used to secure the applicant’s satisfactory fulfilment of its contractual performance obligations toward the beneficiary. For example, should the applicant fail to perform a contracted duty such as: complete a construction project, or repair equipment, or build a home or road within the contracted specifications and/or timelines, then the beneficiary will be entitled to present a drawing statement.

Counter SBLC

An applicant or the beneficiary may require a local SBLC to be issued directly by an overseas, reputable party - most often a bank - in the same country as the beneficiary.

The applicant may not have the means or would prefer not to open another line of credit with an overseas party to facilitate this limited need. In this case, they would request an issuer to issue a counter SBLC. The counter SBLC provides collateral to a local party or bank (often a correspondent of the issuer of the counter-undertaking), to induce that bank to issue its own separate and distinct, local undertaking.

In these instances, there are two undertakings:

• The 1st is the counter-SBLC between the issuer and the local bank
• The 2nd is the local undertaking between the local issuer and the beneficiary

The undertaking type and/or their governing rule sets do not need to be like for like. Each bank has its own policies toward issuing and receiving counter SBLCs.

Through the use of counter SBLCs, a client maintains a single line of credit.

A counter SBLC may be necessary in the following scenarios:

• Beneficiary requires/demands a local SBLC or guarantee;
• Beneficiary requires a “local bank” to issue the final undertaking and will not allow another local bank to advise or confirm it;
• The undertaking or guarantee must be subject to laws outside of the issuer’s policies.

The beneficiary of the counter-SBLC is the financial institution requested to issue its own instrument. The beneficiary of the second instrument is the applicant’s counterparty in the underlying contract/agreement.

The drawing requirements for a counter-SBLC generally require a simple statement that the second financial institution received a demand for payment against the instrument it issued. The drawing requirements under the second instrument will have ultimately been provided by the applicant of the counter SBLC issuer.

Example of a typical process flow for a counter SBLC

What is the difference between an SBLC and a Commercial Lettter of Credit?

Costs – Costs between SBLCs and Commercial LCs usually differ.

At a high level both types of LC typically require an issuer to consider factors such as:

• Applicant/client size
• Collateral and required line of credit size
• The issuer’s internal LC processing costs
• Credit establishment and compliance risk costs
• The differences of the types of LCs anticipated to be requested

Depending on the laws applicable to the Issuer, there may be different cash reserve loss requirements needed for commercial LCs vs performance SBLCs vs financial SBLCs, (Note: This is the case for all countries following Basel) which may affect the issuing/opening fee.

Both LC types will require an applicant to pay an issuance fee of some type. However, commercial LCs are expected to have at least one, if not multiple document presentations. Each presentation will typically be assessed by an examination fee of some type. Conversely, most SBLCs do not receive a beneficiary’s document presentation or drawing and so no examination related fees will be assessed.

Where a SBLC generally covers longer term and ongoing contracts, the issuance fee is needed for the duration of the SBLC.

Commercial LCs are typically issued to support a single need e.g. to cover a payment for: a) a shipment of goods; or b) services completed. They typically expire earlier than a SBLC.

For applicants and beneficiaries which routinely transact, a longer term SBLC may be the more economical LC undertaking, instead of issuing multiple commercial LCs. The commercial LCs will be assessed multiple issuance and examination fees.

Document presentations – Commercial LCs are a beneficiary’s primary payment option. Rather than relying on the underlying contract for payment, the beneficiary will request payment from the issuer’s independent commercial LC undertaking in settlement of the underlying contract they have with the applicant. Conversely, SBLCs take the opposite view and, in the overwhelming majority of cases, the issuer of a SBLC does not expect to receive a document presentation nor make a payment.

As a secondary payment option to the beneficiary, if a document presentation/demand is received, it generally means that the applicant has failed to meet its terms against the underlying contract.

Document types – Commercial LCs require documentary presentations which usually consist of commercial documents such as commercial invoices, packing or weight lists, transport documents, etc. SBLCs are payable most often against simple beneficiary statements and the documents presented often have no intrinsic value.

Misstatements/Fraud – Understanding the difference with document types outlined above, the possibility of a beneficiary requesting a payment in error, by accident or purposely are greater with a SBLC. While a very rare occurrence, it is recommended that the applicant and beneficiary have an established relationship when dealing with SBLCs.

Duration - Commercial LCs are typically short term in nature and their expiry date is generally 6 months or less. SBLCs most often cover longer term contracts, and their duration may be years in length on an overall basis.

Tenors – Any LC undertaking must define the period when a complying document presentation is due for payment and this period is known as the LC’s tenor. As LC undertakings, both Commercial LCs and SBLC’s can be payable “at sight”. This means upon a reasonable time from when the nominated or issuer has found the documents to comply with an LC’s terms.

Conversely there also exists time tenors, which detail that a payment is to be made at a fixed future certain date from the time a presentation is found to be complying. Time tenors are typically referred to as Deferred Payment Undertakings or Banker’s Acceptances. One term, “Negotiation”, may be used as a sight or time tenor.

Commercial LCs often include some form of financing need for trade and, as such, time tenors are utilized. SBLCs which generally do not expect a presentation or demand for payment will overwhelmingly use the sight tenor.

Terms and Conditions – Given their very different payment needs, the data content of commercial versus SBLCs differs significantly.

Purpose  – Commercial LCs facilitate trade and are issued with the intention that a document presentation will be delivered to a bank for payment for a shipment of goods or payment for services.  They are the primary payment vehicle for the beneficiary.

On the other hand, SBLCs cover any type of contract or agreement between two parties.  Provided the issuer is willing to support its applicant, the type of contract a SBLC can support is boundless and includes the different types we covered above (which is not an exhaustive list).

When an applicant does not meet its contracted duty(ies), the beneficiary will make a claim against the applicant for payment under the underlying contract.  When the applicant fails to honour the request for payment, the beneficiary will make a presentation for payment against the SBLC making it a secondary payment vehicle, or payment of last resort for a beneficiary.

SBLCs vs Bank Guarantees

Similar to the commercial LC or a SBLC, a demand guarantee (DG) is an independent and irrevocable “undertaking,” provided by an issuer to a beneficiary, that provides assurance of payment upon receipt of complying document presentations.

DGs are often referred to as first demand guarantees. DGs are more common in Europe, Asia, and the Middle East. SBLCs are more common in the Americas, however they remain globally issued and/or accepted.

Surety or ancillary guarantees should not be confused with DGs and are not the same as LC undertakings. They are outside the scope of this guide.

DGs and SBLCs are extremely similar “undertakings” with the key differences provided by its governing rule set. Like the SBLC, demand guarantees:

• Require the beneficiary to present a compliant documentary demand in order to receive payment against the undertaking
• Are independent from the underlying contract
• Do not require the issuer to investigate the legitimacy of a demand.

When included in a SBLC, UCP600 or ISP98  will govern the instrument and provide a series of default resolutions in cases where a SBLC is silent. Conversely, when included in a DG, the Uniform Rules for Demand Guarantees (URDG 758) will govern and provides it defaults resolutions.

While some defaults are similar, there are significant differences in the approach taken by the rule sets especially in areas such as:

• Force Majeure situations
• Document examination period and approach
• Confirmation
• Allowable payment tenors
• Required notifications to an applicant
• Governing law and jurisdiction
• Replacing a DG or SBLC undertaking lost by a beneficiary
• Some terminology differences e.g. guarantor versus issuing party.

Most banks will require a DG to be subject to the URDG 758 to normalize the roles and responsibilities of each party to the undertaking. Issuing a DG that is silent as to its governing rule set and/or is subject to laws of another country, creates potential risk for the issuer (guarantor is the issuer for DGs) and the applicant. This is because the roles and responsibilities may not be directly addressed, well known or understood.

SBLC rules and regulations

Below is an overview of the key regulations, codes and rules that govern SBLCs.

International Standby Practice (ISP98)

• ISP is a set of rules that when incorporated into an undertaking by referencing the ISP98 or ICC publication 590, will cause the undertaking to be deemed as a Standby Letter of Credit.
• The ISP was approved and endorsed by the International Chamber of Commerce (ICC) in January 1999 (ICC publication 590).
• The ISP took more than five years to create and it was the result of interaction between individuals, banks, and national and international associations.
• The ISP98 is a copyright of the Institute of International Banking Law & Practice (IIBLP) .
• ISP is not law, but it contains resemblances to USA L/C legal doctrine.
• It represents a more comprehensive rule set for SBLCs versus the UCP 600.

Uniform Customs and Practice (UCP 600)

• UCP is a set of rules that that when incorporated into an undertaking, will cause the undertaking to be deemed as a letter of credit.
• The primary focus of the UCP is to govern commercial letters of credit. However, as noted in UCP Article 1 in parenthesis, UCP applies to standby letters of credit “to the extent to which they are applicable”.
• UCP is not a law, rather a set of articles developed by the International Chamber of Commerce (ICC) Banking Commission and others. They are copyrighted by the ICC
• ICC is a non-governmental organization.
• UCP was first published in 1933 making it the oldest and most legally tested rule set. Thereafter revised in 1951, 1962, 1974, 1983, 1993 and its current revision in 2007.
• Receiving a document presentation which contains an extend or pay request e.g. request to extend the expiration date of the SBLC or pay the presentation
• Issuances of counter-SBLCs;
• Examining documents against a SBLC which requires a document to make and/or complete a statement utilizing quotation marks; require a witness, etc.
• What to do in cases where a beneficiary has merged or been acquired after issuance of an SBLC
• Syndicated or participated deals.

Uniform Rules for Demand Guarantees (URDG 758)

• The URDG is a set of rules that that when incorporated into an undertaking, will cause the undertaking to be deemed a demand guarantee (DG).
• URDG 758 entered into effect July 2010 and is a complete revision of the original revision URDG 458.
• The URDG rules support demand guarantees, not surety guarantees.
• Where possible, it was aligned with the concepts of UCP 600; however, its default positions differ from UCP and ISP in a variety of manners.
• URDG 758 now has a companion document titled the International Standard Demand Guarantee Practice (ISDGP) for URDG 758 (ICC publication 814E) . It supplements the URDG by identifying and recording best practice in relation to the URDG rules and beyond.

                                                                                                                                                                                                  Evergreen clauses

Given the long-term expiry nature of SBLCs, they often insert what is commonly referred to as an “Evergreen” or “automatic-extension” clause. The Evergreen Clause allows an SBLC’s expiry date to automatically extend for a fixed period-of-time (e.g. every six months or year).

It also provides an issuer or confirmer and/or the applicant with an exit period (e.g. “unless XX days prior to any then current expiration date, the issuer notifies the beneficiary that the issuer elects not to extend the SBLC”). This allows them the possibility to have the SBLC expiry with a simple cancellation notification and without the need for a beneficiary to agree to an amendment.

However, any cancellation notification must be sent or received by the beneficiary by the notification period indicated in the SBLC’s specific evergreen clause. This is normally anywhere between 30 and 90 days from a then current expiration date.

How Evergreen clauses benefit SBLCs

The applicant, issuer or confirmer is provided with the means to close the SBLC without the need for a beneficiary to consent or otherwise have to agree to an amendment or return an undertaking. (Note: The cancellation is typically sent when the underlying contract is also close to completion, but there remain other reasons for cancellation such as: applicant seeking to replace an issuer for improved costs or other reasons, or an issuer seeking to remove itself from a deal; etc.)

In addition, providing longer-term commitments often requires higher rates/fees. The exit opportunity provided by an Evergreen Clause may keep fees more reasonable.

SBLC frequently asked questions

See the section above that covers this in detail

SBLC undertakings can support “any” type of underlying contract, agreement, or obligation between an issuer’s client or applicant and the applicant’s client/counterparty - the beneficiary - provided the issuer is willing to support the nature of the underlying contract.

The SBLC obligations supplement and are in addition to any other underlying contract/agreement between the issuer’s client, the applicant and the beneficiary. When the issuer bears a stronger credit rating, a SBLC is also a credit enhancement tool.

An applicant could require that a beneficiary must inform them of an intended drawing XX days in advance. The SBLC could require the beneficiary to make this certification and provide some form of documentary evidence; e.g. a copy of an email to ensure it was completed. This notification could allow an applicant to resolve the contract issue negating the need for a drawing.

Conversely, a trusted neutral third party or an applicant could require that a beneficiary’s drawing statement be countersigned or attested by a third party neutral to the applicant and beneficiary; or the applicant or their representative to help ensure that the drawing is warranted (Note: Given the neutrality of a SBLC between an issuer and a beneficiary, having an applicant requirement to countersign or attest to a drawing is discouraged in rules and often prohibited by an issuer and/or a beneficiary).

Most SBLCs have a sight tenor and, as noted throughout this guide, in most cases a SBLC will never receive a presentation or drawing so there is no need to make a payment.

Discounting or prepaying a sight SBLC can be associated with fraud and as such, caution is needed when considering such a possibility.

Yes, and as noted in UCP 600, ISP98 (and URDG 758) and when allowed by applicable law, in certain cases the issuer may issue a SBLC on its own behalf.  In these cases, the issuer becomes the applicant and the issuer.  This is commonly known as a two party SBLC.

About the author

Glenn Ransier Technical Advisor, ICC Banking Commission; Member of URDG 758 drafting team; and Co-Chair for the ISDGP

Head of Documentary Trade and Standby LCs with Wells Fargo Bank N.A .

Email: [email protected]

Disclaimer: Contents represent the author’s sole opinions and may not represent those of any past, present or future employer.

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Letter of Credit: How to prepare “draft”

Trade and export finance expert Domenico Del Sorbo’s take on how to prepare the “draft” in accordance with the letter of credit conditions and provisions.

By Domenico Del Sorbo

Last modified Monday April 15, 2024

Estimated reading time: 8 minutes

In UCP 600 article 2, the ICC indicates that a “Complying presentation means a presentation that is in accordance with the terms and conditions of the credit, the applicable provisions of these rules and international standard banking practice.” 

The beneficiary of a documentary credit must, in order to obtain the expected benefits from the bank, prepare the documents required by the letter of credit in accordance with the hierarchy of letter of credit terms, the provisions of the UCP 600 and the international standard banking practice partially but widely encoded in the ICC publication ISBP 745.

Below is a walk-through on how to prepare the “draft” in accordance with the letter of credit conditions and the above-mentioned provisions.

The “draft”: what is it?

The bill of exchange is a negotiable instrument through which a creditor (drawer) orders a debtor (drawee) to pay a certain sum to the legitimate bearer of the title (beneficiary), either on demand or at a set time. 

The drawee becomes obliged only if they accept the bill of exchange. To be considered legally an undertaking, the document must comply with the requirements of the “applicable bill of exchange law.” Under a letter of credit, usually, the drawer and beneficiary are the same person.

The “applicable bill of exchange law” refers to two major regulatory systems:

• The British 1882 Bills of Exchange Act referring to the United Kingdom, Ireland and several Commonwealth countries such as Cyprus, Australia, India, Hong Kong, Israel, New Zealand, Malaysia, Pakistan, Philippines, Singapore, Sri Lanka, Bangladesh
• The Geneva Convention of 1930 (Conventions Providing a Uniform Law for Bills of Exchange and Promissory Notes) refers to the countries of continental Europe, several Latin American countries, the Middle East and Asia (some countries have ratified the Convention, others are inspired to define internal rules).

The Geneva Convention of 1930 is more specific and formal than the “Bill of Exchange Act” of 1882. If a bill of exchange meets the requirements of the Geneva Convention, it automatically meets the requirements of the Bill of Exchange Act of 1882.

Article 1 of the Geneva Convention of 1930 states the following: “A bill of exchange contains:

• The term ‘bill of exchange’ inserted in the body of the instrument and expressed in the language employed in drawing up the instrument;
• An unconditional order to pay a determinate sum of money;
• The name of the person who is to pay (drawee);
• A statement of the time of payment;
• A statement of the place where payment is to be made;
• The name of the person to whom or to whose order payment is to be made;
• A statement of the date and of the place where the bill is issued;
• The signature of the person who issues the bill (drawer).”

The UCP 600, ICC article 2, is dedicated to the definitions and states the following:

“Honour means:

• To pay at sight if the credit is available by sight payment.
• To incur a deferred payment undertaking and pay at tenor if the credit is available by deferred payment.
• To accept a bill of exchange (“draft”) drawn by the beneficiary and pay at tenor if the credit is available by acceptance .”

“Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which the reimbursement is due to the nominated bank.”

Therefore, the “draft”, which is issued by the beneficiary “to his own order” (the beneficiary of the bill of exchange coincides with the beneficiary of the credit) is required in the letter of credits available “by acceptance” or “by negotiation”, and sometimes also in the letter of credits available “by payment”, with a request for “sight draft”.

It should be noted that “by acceptance”, letter of credits differ from “by deferred payment” letter of credits only for the use of the “draft” as an instrument to honour the amount to its tenor. 

In order to obtain post-shipment financing, the beneficiary can alternatively endorse the bill of exchange accepted by the bank – under a complying presentation – to third parties or transfer the proceeds of the credit through an “Assignment of Proceeds” to third parties. 

In both cases, the paying bank will fix the amount to the beneficiary or to third parties: to the “assigner” in the case of “by deferred payment” letter of credit or the bearer of the bill of exchange in the case of the letter of credits available “by acceptance”.

Therefore, the only difference between “by acceptance” and “deferred payment” credits relates to the form of the bank’s payment undertaking that will be in line with applicable regulatory practices to eventually discount the bank’s undertaking.

“Draft”: What does the UCP 600 say?

Article 6 of the UCP 600 ICC states that, “A credit must not be issued available by a draft drawn on the applicant.”. Therefore, a credit cannot be issued where the name of the application appears as a “drawee” (field 42A message Swift MT 700 ).

However, it is considered to be entirely in line if a letter of credit calls for a draft drawn on the applicant under the required documents (and thus in the 46A field of the Swift MT700 message) and this document will be examined only with reference to what is required in the credit and according to article. 14 (f) UCP 600 ICC, which reads as follows: 

“If a credit requires presentation of a document other than a transport document, insurance document or commercial invoice, without stipulating by whom the document is to be issued or its data content, banks will accept the document as presented if its content appears to fulfil the function of the required document and otherwise complies with sub-article 14 (d)”. 

Sub-article 14, point d) states that, “Data in a document, when read in context with the credit, the document itself and the international standard banking practice, need not be identical to, but must not conflict with, data in that document, any other stipulated document or the credit”. 

Therefore, if – always referring to the draft drawn on the applicant under the documents required in a letter of credit – neither the issuer nor the data it must contain are specified, the banks will have to accept a document issued by the beneficiary whose content appears to respect the function of the required document.

In addition, the data indicated therein may not be identical to what is specified in the letter of credit or other required documents, but they should not be in conflict with them.

It’s important to note that the draft must contain all the terms expressly required by a letter of credit. The general conditions that apply to “all documents” does not apply to the “draft”, unless a letter of credit calls for a one to be drawn on the applicant under required documents in the credit. 

The ICC Banking Commission, in the Opinion TA 703rev, has stated that “a draft is not to be considered as one of those required documents unless the credit requires the presentation of a draft drawn on the applicant under “documents required”.

“Draft”: ISBP 745 ICC viewpoint

Below are further indications – not exhaustive – about the correct setting of the “draft” in reference to what is stated in paragraphs B1 – B18 of the ISBP 745:

The tenor of the “draft” must be in line with credit terms. If the credit requires a “draft other than sight or a certain period after sight”, it must be possible to determine the tenor from the data given in the same draft.

For example, if a credit requires a “draft at 60 days after Bill of Lading Date” and the Bill of Lading date is 14/05/2013 (refer to the on-board date and not the date of issue of the Bill of Lading), the tenor must be structured in one of the following ways:

• “60 days after bill of lading date 14 May 2013”;
• “60 days after 14 May 2013”;
• “60 days after bill of lading date” indicating elsewhere in the document: “bill of lading date 14 May 2013”;
• “60 days date” on a “draft” dated the same day as the Bill of Lading date;
• “13 July 2013”, i.e, 60 days after Bill of Lading’s date.

It should be noted that the same principle also applies in the presence of transport documents other than Bill of Lading.

A “draft” must be issued and signed by the beneficiary of the credit and must indicate a date of issue.

If the credit indicates, as a “drawee” of a draft, the Swift code of a bank, the “draft” may indicate such Swift code or the bank’s full name.

If the credit is available by “negotiation” with a nominated bank or “any bank”, the “draft” must be issued to a bank other than the nominated.

If the credit is available by “acceptance” with “any bank”, the “draft” must be issued to the bank that is available to accept the “draft” and therefore, available to act as nominated.

The “draft” is to be issued for the amount required in the presentation. In case of discrepancy between the amount indicated in letters and the amount indicated in figures, the amount indicated in the letters will be examined.

Any correction of data on a draft needs authentication with the addition of the signature or initials of the beneficiary. 

A draft is to be endorsed, if necessary.

Conclusions

In conclusion, it should be emphasised that the documents to be presented in the use of a letter of credit must be prepared in accordance with the terms of the letter of credit, the provisions of the UCP 600 and international banking standard practice, following its hierarchy.

The preparation of the invoice – a document required virtually in all letters of credit is necessary, as we have seen, to comply with various regulatory provisions.

About the Author(s)

Domenico Del Sorbo

Dr. Domenico Del Sorbo, is an expert in trade and export finance tools and, in particular, international payments with a specialised focus on risk-mitigation tools (letters of credit, standby letter of credit and demand guarantees).

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Letter of Credit for Business

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Imagine if you had to write down in a notebook all your expenses, income, checks, bill payments, savings... You would never finish! Fortunately, banks keep an exhaustive control of all this and if you need it, you can ask for bank statements to have the letters of credit of certain movements in your bank account. This is very useful especially for companies, which have large expenses and income. And if you are the one in charge of preparing the bank statements? Well, use in your bank these designs here already prepared with the banking information of this type of documents, simply ready for you to automate them in your bank. And they come ready to print, so the customer can have them at his disposal very quickly.

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Table of Content

What is a Letter of Credit?

Why is letter of credit important, features / characteristics of letter of credit, documents required for a letter of credit, how does letter of credit work, letter of credit - process, letter of credit with example, letter of credit sample format, types of letter of credit, bank guarantee vs letter of credit.

Explore Drip Capital’s Innovative Trade Financing Solutions

31 August 2022

Letter of Credit (LC) - Meaning, Process & Role In International Trade

There are several uncertainties that arise when buyers and sellers across the globe engage in maritime trade operations. Some of these uncertainties revolve around delayed payments, slow deliveries, and financing-related issues, among others. The sheer distances involved in international trade, different laws and regulations, and changing political landscape are just some of the reasons for sellers needing a guarantee of payment when they deliver goods through the maritime route to their sellers. Letters of credit were introduced to address this by adding a third party like a financial institution into the transaction to mitigate credit risks for exporters.

A letter of credit or LC is a written document issued by the importer’s bank (opening bank) on importer’s behalf. Through its issuance, the exporter is assured that the issuing bank will make a payment to the exporter for the international trade conducted between both the parties.

The importer is the applicant of the LC, while the exporter is the beneficiary. In an LC, the issuing bank promises to pay the mentioned amount as per the agreed timeline and against specified documents.

A guiding principle of an LC is that the issuing bank will make the payment based solely on the documents presented, and they are not required to physically ensure the shipping of the goods. If the documents presented are in accord with the terms and conditions of the LC, the bank has no reason to deny the payment.

A letter of credit is beneficial for both the parties as it assures the seller that he will receive his funds upon fulfillment of terms of the trade agreement and the buyer can portray his creditworthiness and negotiate longer payment terms, by having a bank back the trade transaction.

A letter of credit is identified by certain principles. These principles remain the same for all kinds of letters of credit. The main characteristics of letters of credit are as follows:

Negotiability

A letter of credit is a transactional deal, under which the terms can be modified/changed at the parties assent. In order to be negotiable, a letter of credit should include an unconditional promise of payment upon demand or at a particular point in time.

Revocability

A letter of credit can be revocable or irrevocable. Since a revocable letter of credit cannot be confirmed, the duty to pay can be revoked at any point of time. In an irrevocable letter of credit , all the parties hold power, it cannot be changed/modified without the agreed consent of all the people.

Transfer and Assignment

A letter of credit can be transferred, also the beneficiary has the right to transfer/assign the LC. The LC will remain effective no matter how many times the beneficiary assigns/transfers the LC.

Sight & Time Drafts

The beneficiary will only receive the payment upon maturity of letter of credit from the issuing bank when he presents all the drafts & the necessary documents.

• Shipping Bill of Lading
• Airway Bill
• Commercial Invoice
• Insurance Certificate
• Certificate of Origin
• Packing List
• Certificate of Inspection

LC is an arrangement whereby the issuing bank can act on the request and instruction of the applicant (importer) or on their own behalf. Under an LC arrangement, the issuing bank can make a payment to (or to the order of) the beneficiary (that is, the exporter). Alternatively, the issuing bank can accept the bills of exchange or draft that are drawn by the exporter. The issuing bank can also authorize advising or nominated banks to pay or accept bills of exchange.

Fee and charges payable for an LC

There are various fees and reimbursements involved when it comes to LC. In most cases, the payment under the letter of credit is managed by all parties. The fees charged by banks may include:

Opening charges, including the commitment fees, charged upfront, and the usance fee that is charged for the agreed tenure of the LC.

Retirement charges are payable at the end of the LC period. They include an advising fee charged by the advising bank, reimbursements payable by the applicant to the bank against foreign law-related obligations, the confirming bank’s fee, and bank charges payable to the issuing bank.

Parties involved in an LC

Main parties involved:

Applicant An applicant (buyer) is a person who requests his bank to issue a letter of credit.

Beneficiary A beneficiary is basically the seller who receives his payment under the process.

Issuing bank The issuing bank (also called an opening bank) is responsible for issuing the letter of credit at the request of the buyer.

Advising bank The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter.

Other parties involved in an LC arrangement:

Confirming bank The confirming bank provides an additional guarantee to the undertaking of the issuing bank. It comes into the picture when the exporter is not satisfied with the assurance of the issuing bank.

Negotiating bank The negotiating bank negotiates the documents related to the LC submitted by the exporter. It makes payments to the exporter, subject to the completeness of the documents, and claims reimbursement under the credit.

(Note:- Negotiating bank can either be a separate bank or an advising bank)

Reimbursing bank The reimbursing bank is where the paying account is set up by the issuing bank. The reimbursing bank honors the claim that settles the negotiation/acceptance/payment coming in through the negotiating bank.

Second Beneficiary The second beneficiary is one who can represent the original beneficiary in their absence. In such an eventuality, the exporter’s credit gets transferred to the second beneficiary, subject to the terms of the transfer.

The process of getting an LC consists of four primary steps, which are enlisted here:

Step 1 - Issuance of LC

After the parties to the trade agree on the contract and the use of LC, the importer applies to the issuing bank to issue an LC in favor of the exporter. The LC is sent by the issuing bank to the advising bank. The latter is generally based in the exporter’s country and may even be the exporter’s bank. The advising bank (confirming bank) verifies the authenticity of the LC and forwards it to the exporter.

Step 2 - Shipping of goods

After receipt of the LC, the exporter is expected to verify the same to their satisfaction and initiate the goods shipping process.

Step 3 - Providing Documents to the confirming bank

After the goods are shipped, the exporter (either on their own or through the freight forwarders ) presents the documents to the advising/confirming bank.

Step 4 - Settlement of payment from importer and possession of goods

The bank, in turn, sends them to the issuing bank and the amount is paid, accepted, or negotiated, as the case may be. The issuing bank verifies the documents and obtains payment from the importer. It sends the documents to the importer, who uses them to get possession of the shipped goods.

Suppose Mr A (an Indian Exporter) has a contract with Mr B (an importer from the US) for sending a shipment of goods. Both parties being unknown to each other decide to go for an LC arrangement.

The letter of credit assures Mr A that he will receive the payment from the buyer and Mr B that he will have a systematic and documented process along with the evidence of goods having been shipped.

From this point on, this is how a letter of credit transaction would unveil between Mr A & Mr B:-

Mr B (buyer) goes to his bank that is the issuing bank (also called an opening bank) and issues a Letter of Credit.

The issuing bank further processes the LC to the advising bank (Mr A's bank).

The advising bank checks the authenticity of the LC and sends it to Mr A.

Now that Mr A has received the confirmation he will ship the goods and while doing so he will receive a Bill of Lading along with other necessary documents.

Further, he will send these documents to the negotiating bank.

The negotiating bank will make sure that all necessary requirements are fulfilled and accordingly make the payment to Mr A (the seller).

Additionally, the negotiating bank will send all the necessary documents to the issuing bank.

Which again the issuing bank will send to Mr B (Buyer) to confirm the authenticity.

Once Mr B has confirmed he will make the payment to the issuing bank.

And the issuing bank will pass on the funds to the negotiating bank.

To understand the process clearly refer to this image:

Following are the most commonly used or known types of letter of credit:-

Revocable Letter of Credit

Irrevocable Letter of Credit

Confirmed Letter of Credit

Unconfirmed Letter of Credit

LC at Sight

Usance LC or Deferred Payment LC

Back to Back LC

Transferable Letter of Credit

Un-transferable Letter of Credit

Standby Letter of Credit

Freely Negotiable Letter of Credit

Revolving Letter of Credit

Red Clause LC

Green Clause LC

To understand each type in detail read the article, Types of letter of credit used in International Trade .

What is the application process for an LC?

Importers have to follow a specific procedure to follow for the application of LCs. The process is listed here:

• After a sales agreement is created and signed between the importer and the exporter, the importer applies to their bank to draft a letter of credit in favor of the exporter.
• The issuing bank (importer’s bank) creates a letter of credit that matches the terms and conditions of the sales agreement before sending it to the exporter’s bank.
• The exporter and their bank need to evaluate the creditworthiness of the issuing bank. After doing so and verifying the letter of credit, the exporter’s bank approves and sends the document to the importer.
• After that, the exporter manufactures and ships the goods as per the agreed timeline. A shipping line or freight forwarder assists with the delivery of goods.
• Along with the goods, the exporter also submits documents to their bank for compliance with the sales agreement.
• After approval, the exporter’s bank then sends these complying documents to the issuing bank.
• Once the documents are reviewed, the issuing bank releases the payment to the exporter and sends the documents to the importer to collect the shipment.

What are the Benefits of an LC?

A letter of credit is beneficial for both parties as it assures the seller that they will receive their funds upon fulfillment of the terms of the trade agreement, while the buyer can portray his creditworthiness and negotiate longer payment terms by having a bank back the trade transaction.

Letters of credit have several benefits for both the importer and the exporter. The primary benefit for the importer is being able to control their cash flow by avoiding prepayment for goods. Meanwhile, the chief advantage for exporters is a reduction in manufacturing risk and credit risk. Ultimately, since the trade deals are often international, there are factors like location, distance, laws, and regulations of the involved countries that need to be taken into account. The following are advantages of a letter of credit explained in detail.

LC reduces the risk of late-paying or non-paying importers There might be instances when the importer changes or cancels their order while the exporter has already manufactured and shipped the goods. The importers could also refuse payment for the delivered shipments due to a complaint about the goods. In such circumstances, a letter of credit will ensure that the exporter or seller of the goods receives their payment from the issuing bank. This document also safeguards if the importer goes into bankruptcy.

LC helps importers prove their creditworthiness Small to midsize businesses do not have vast reserves of capital for managing payments for raw materials, equipment, or any other supplies. When they are in a contract to manufacture a product and send it to their client within a small window, they cannot wait around to free up capital for buying supplies. This is where letters of credit come to their rescue. A letter of credit helps them with important purchases and serves as proof to the exporter that they will fulfill the payment obligations, thus avoiding any transaction and manufacturing delays.

LCs help exporters with managing their cash flow more efficiently A letter of credit also ensures that payment is received on time for the exporters or sellers. This is especially important if there is a huge period of time between the delivery of goods and payment for them. Ensuring timely payments through the letter of credit will go a long way in helping the exporters manage their cash flow. Furthermore, sellers can obtain financing between the shipment of goods and receipt of payment, which can provide an additional cash boost in the short term.

A Bank guarantee is a commercial instrument. It is an assurance given by the bank for a non-performing activity. If any activity fails, the bank guarantees to pay the dues. There are 3 parties involved in the bank guarantee process i.e the applicant, the beneficiary and the banker.

Whereas, a Letter of Credit is a commitment document. It is an assurance given by the bank or any other financial institution for a performing activity. It guarantees that the payment will be made by the importer subjected to conditions mentioned in the LC. There are 4 parties involved in the letter of credit i.e the exporter, the importer, issuing bank and the advising bank (confirming bank).

Things to consider before getting an LC

A key point that exporters need to remind themselves of is the need to submit documents in strict compliance with the terms and conditions of the LC. Any sort of non-adherence with the LC can lead to non-payment or delay and disputes in payment.

The issuing bank should be a bank of robust reputation and have the strength and stability to honor the LC when required.

Another point that must be clarified before availing of an LC is to settle the responsibility of cost-bearing. Allotting costs to the exporter will escalate the cost of recovery. The cost of an LC is often more than that of other modes of export payment. So, apart from the allotment of costs, the cost-benefit of an LC compared to other options must also be considered.

FAQs on Letter of Credit

1. is letter of credit safe.

Yes. Letter of Credit is a safe mode of payment widely used for international trade transactions.

2. How much does it cost for a letter of credit?

Letters of credit normally cost 1% of the amount covered in the contract. But the cost may vary from 0.25% to 2% depending on various other factors.

3. Can a letter of credit be cancelled?

In most cases letters of credit are irrevocable and cannot be cancelled without the agreed consent of all parties.

4. Can a letter of credit be discounted?

A letter of credit can be discounted. While getting an LC discounted the supplier or holde of LC should verify whether the issuing bank is on the approved list of banks, with the discounting bank. Once the LC is approved, the discounting bank releases the funds after charging a certain amount as premium.

5. Is a letter of credit a not negotiable instrument?

A letter of credit is said to be a negotiable instrument, as the bank has dealings with the documents and not the goods the transaction can be transferred with the assent of the parties.

6. Are letters of credit contingent liability?

It would totally depend on future circumstances. For instance, if a buyer is not in a condition to make the payment to the bank then the bank has to bear the cost and make the arrangement on behalf of the buyer.

7. A letter of credit is with recourse or without recourse?

A 'without recourse' letter of credit to the beneficiary is a confirmed LC. Whereas an unconfirmed or negotiable letter of credit is 'with recourse' to the beneficiary.

8. Who is responsible for letters of credit?

The issuing bank takes up the responsibility to complete the payment if the importer fails to do so. If it is a confirmed letter of credit, then the confirming bank has the responsibility to ensure payment if the issuing bank and importers fail to make the payment.

The Uniform Customs and Practice for Documentary Credits (UCP) describes the legal framework for all letters of credit. The current version is UCP600 which stipulates that all letters will be irrevocable until specified.

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Siddhi Parekh

Finance manager at drip capital.

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