Four types of letters of credit are Documentary, Standby, Revocable/Irrevocable, and Transferable. Letters of credit (LCs) are crucial instruments in international trade, providing a guarantee of payment from a bank to a seller on behalf of a buyer. Here's a more detailed look at each type:
1. Documentary Letter of Credit
A documentary letter of credit is the most common type. It ensures payment to the seller only when specific documents, as stipulated in the credit, are presented and comply with the terms of the LC. These documents typically include:
- Commercial invoice
- Packing list
- Bill of lading
- Insurance certificate
This type provides security for both the buyer and the seller by verifying that the goods have been shipped and meet the agreed-upon specifications before payment is made.
2. Standby Letter of Credit
A standby letter of credit functions more like a guarantee. It is used when the buyer defaults on a payment or fails to fulfill a contractual obligation. The beneficiary (seller) can then draw on the standby LC by presenting documents proving the buyer's non-performance. Unlike a documentary LC, a standby LC is not typically used for routine trade transactions but rather as a safety net in case of default.
3. Revocable and Irrevocable Letters of Credit
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Revocable LC: A revocable letter of credit can be amended or cancelled by the issuing bank (on instructions from the buyer) at any time without prior notice to the beneficiary (seller). This type offers very little security to the seller and is rarely used.
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Irrevocable LC: An irrevocable letter of credit cannot be amended or cancelled without the agreement of all parties involved (the issuing bank, the confirming bank, and the beneficiary). This provides a much stronger guarantee to the seller, ensuring payment if they comply with the terms of the LC.
4. Transferable Letter of Credit
A transferable letter of credit allows the first beneficiary (usually a middleman or trading company) to transfer all or part of the credit to one or more second beneficiaries (the actual suppliers of the goods). This is useful when the initial beneficiary is not the original supplier but rather acts as an intermediary in the transaction.
In addition to these four, other types of letters of credit exist, such as Back-to-Back LCs, Revolving LCs, Confirmed LCs, Sight LCs, and Usance LCs, each serving specific needs in international trade finance. However, Documentary, Standby, Revocable/Irrevocable, and Transferable are the primary and most widely recognized categories.
