ypes of Letters of Credit

Traveler's letters of credit, which were commonly used in eighteenth century,

were the first financial instrument contains very similar characteristics with the
contemporary letters of credit.

Commercial Letters of Credit

Commercial letters of credit are mainly used as a primary payment tool in
international trade such as exporting and importing transactions. Majority of
commercial letters of credit are issued subject to the latest version of UCP
(Uniform Customs and Practice for Documentary Credits). The ICC publishes
UCP, which are the set of rules that governs the commercial letters of credit
procedures.

Standby Letters of Credit

Commercial letters of credit are a means of payment to be utilized when the
principal perform its duties. As an example, let us consider an exporter who
ships the goods according to the sales contract and apply to the nominated
bank for the payment. If the nominated bank decides that the presentation is
conforming to the terms and conditions of the credit and the UCP rules then
exporter will be paid. This situation is just contrary in standby letters of credit.

A payment is made to the beneficiary of a standby letter of credit when there is

a breach of the principal's obligation. As an example, let us consider a
construction company that has been awarded with a tender. If this construction
company cannot fulfill its obligations under the project contract beneficiary of
the standby letter of credit can apply to the nominated bank for the payment.
However, the nominated bank considers only the terms and the conditions of
the standby letter of credit and the rules governing the credit when deciding a
complying presentation. One point that needs to be stressed is that standby
letters of credit have their own rules, which are called The International Standby
Practices 1998 (ISP98). They are also published by ICC. However, a standby
letter of credit can be issued subject to either the UCP or the ISP.

Revocable Letters of Credit

Revocable letters of credit give issuer the amendment or cancellation right of
the credit any time without prior notice to the beneficiary. Since revocable
letters of credit do not provide any protection to the beneficiary, they are not
used frequently. In addition, UCP 600 has no reference to revocable letters of
credit. All credits issued subject to UCP 600 are irrevocable unless otherwise
agreed between the parties.

Irrevocable Letters of Credit

Irrevocable Letters of Credit cannot be amended or cancelled without the
agreement of the credit parties. Unconfirmed irrevocable letters of credit cannot
be modified without the written consent of both the issuing bank and the

beneficiary. Confirmed irrevocable letters of credit need also confirming bank's

written consent in order any modification or cancellation to be effective.

From traveler's letters of credit days to today's complex global economy, the
letters of credit have been performing their duties as a secure and
reliable payment method. Actually, during this period letters of credit have
gained a very flexible structure that can satisfy different needs of different types
of international trade practitioners. In this article, we will discuss types of letters
of credit.
Unconfirmed Letters of Credit
Unconfirmed Letters of Credit can be described as a letter of credit, which has
not been guaranteed or confirmed by any bank other than the bank that opened
it. In these types of credits, the only bank that undertakes to honor a complying
presentation is the issuing bank.
Confirmed Letters of Credit
It would be easier to understand the confirmed letters of credit if we start from
the definition of the confirmation.
Confirmation means a definite undertaking of the confirming bank, in addition to
that of the issuing bank, to honor or negotiate a complying presentation.
If a letter of credit's payment undertaking is guaranteed by a second bank, in
addition to the bank originally issuing the credit this kind of credit is called
confirmed letter of credit. The confirming bank agrees to pay or accept drafts
against the credit even if the issuer refuses to do so. Only irrevocable credits
can be confirmed.
Clean Letters of Credit :
Below two different definitions of clean letters of credit are given.
A letter of credit payable upon presentation of the draft, without any supporting
document being required.(www.businessdictionary.com)

L/C that does not require any document other than a written demand for
payment by its beneficiary. In effect, a draft.(www.intracen.org)
Clean letters of credit are issued only by the request of the highest credit
standing companies. It is suitable for variety commercial situations where no
movement of goods is expected. Historically these types of credits have been
used in traveler's letters of credit. Today direct pay standby letter of credit can
be given as an example of clean letters of credit.
There are also some other form of letters of credits which deserve special
attention. We will discuss them by one by more in detail however; you can find
short description of each of them below.
Transferable Letters of Credit
Transferable letter of credit is a documentary credit that is issued with the
option to allow a trader to transfer its rights and obligations to the supplier.
Back-to-Back Letters of Credit
Arrangement in which one irrevocable letter of credit serves as the collateral for
another; the advising bank of the first letter of credit becomes the issuing bank
of the second L/C. Unlike transferable letters of credit, there are two separate
letter of credits exist in back-to-back letter of credit transactions.
Advance Payment (Red Clause) Letters of Credit
Letter of credit that carries a provision (traditionally written or typed in red ink)
which allows a seller to draw up to a fixed sum from the advising or payingbank, in advance of the shipment or before presenting the prescribed
documents.

Applicant
Applicant is the buyer of the goods or services supplied by the seller. Letter of
credit is opened by the issuing bank as per applicant's request. However,
applicant does not belong one of the parties to a letter of credit transaction. This
is because of the fact that letters of credit are separate transactions from the
sale or other contract on which they may be based.
Beneficiary
Beneficiary is the seller of the goods or the provider of the services in a standard
commercial letter of credit transaction. Letter of credit is opened by the issuing
bank in favor of the beneficiary.
Issuing Bank
Issuing Bank is the bank that issues a letter of credit at the request of an
applicant or its own behalf. Issuing bank undertakes to honor a complying
presentation of the beneficiary without recourse.
Nominated Bank
Nominated bank is the bank with which the credit is available or any bank in the
case of a credit available with any bank.
Advising Bank
Advising bank is the bank that advises the credit at the request of the issuing
bank. An advising bank that is not a confirming bank advises the credit and any
amendmend without any obligation to honor.
Confirming Bank

Confirming bank is the bank that adds its confirmation to a credit upon the
issuing bank's authorization or request. Confirming bank may or may not add its
confirmation to a letter of credit. This decision is up to confirming bank only.
However, once it adds its confirmation to the credit confirming is irrevocably
bound to honor or negotiate as of the time it adds its confirmation to the credit.
Even if the issuing bank fails to honor, confirming bank must pay to the
beneficiary.
Reimbursing Bank
Reimbursing Bank shall mean the bank instructed and/or authorized to provide
reimbursement pursuant to a reimbursement authorization issued by the issuing
bank.
Risks in letters of Credit
Although letters of credit are a balanced payment method in terms of risk issues
for both exporters and importers, each letters of credit party bears some
amount of risk. As we have explained before letters of credit transactions are
handled by banks. This responsibility makes the banks one of the parties that
bears risks in a letter of credit transaction.
Risks in letters of credit can be discussed under four groups; general risks in
letters of credit, risks to the applicant, risks to the beneficiary and risks to the
banks.
General Risks in Letters of Credit:
Country Risk: (Political Risk)

The first risk factor that can be mentioned in the general risks group is the
country risk or the political risk. Let us assume that we are an exporter located
in a country X and we have a customer from the country Y. Our customer, which
is from the country Y, opened a L/C in favor of us. We have checked the L/C
conditions and they seem workable. We have produced and shipped the order as
per the L/C and transmit the required documents to the issuing bank before the
expiry date. The issuing bank found our presentation complying and informed us
that they will be honoring our payment claim at the maturity date. However,
before the maturity date due Country Y has changed its export regime, which
makes it impossible for the issuing bank to honor our presentation. This
illustrative is a good example of a country risks. Other examples of country risks
are mass riots, civil war, boycott, sovereign risk and transfer risk.
Fraud Risk:
As we have described before all conditions stated in a letter of credit must be
connected to a document, otherwise banks will disregard such a condition. In
addition, banks deal with only documents but not goods, services or
performance to which the documents may relate. This feature of the letters of
credit is the source of the fraud risk at the same time. As an example, a
beneficiary of a certain letter of credit transaction can prepare fake documents,
which looks complying on their face, to make the presentation to the issuing
bank. As the documents are complying on their face, the issuing bank may
honor the presentation and in this case, the applicant must pay to the issuing
bank for the goods it will never be receiving. Beneficiaries of L/Cs bear also
fraud risks. This happens if an applicant issues a counterfeit letter of credit. In

this case, the beneficiary never receives its payment for the goods it has
shipped.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are nondelivery, goods received with inferior quality, exchange rate risk and the issuing
bank's bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable
to comply with letter of credit conditions, counterfeit L/C, issuing bank's failure
risk and issuing bank's country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount
increases as responsibility of the bank increases.
Why letters of credit are expensive comparing to other payment
methods?
Banks play a key role in letters of credit transactions. This is the main reason
why letters of credit are so expensive comparing to other payment
methods. Issuing banks open letters of credit for the account of applicants
and in favor of the beneficiaries. Issuing banks have to bear certain amount of
risks when they open letters of credit. They also let the applicants benefited
from their credit worthiness. As a commercial institution issuing banks provide
these services only for one reason. To earn more money, to make more
profit. Similarly confirming banks collect fees from the letter of credit parties

for the same reason. When confirming a letter of credit confirming banks may
have to bear substantial amount of non-payment risk. As a result
confirmation fees can sometimes climb to high values. As we have learnt that in
a typical letter of credit transaction there are other banks may exist in addition
to issuing bank and confirming bank such as advising bank, nominated
bank, reimbursing bank. Every additional bank means additional fees and
additional cost for either applicants or beneficiaries.

Letter

of

Credit:

L/C means Letter of Credit. A letter of credit is a document issued by a financial

institution, or a similar party, assuring payment to a seller of goods and/or services
provided certain documents have been presented to the bank. A key principle
underlying letter of credit (L/C) is that banks deal only in documents and not in goods.
LC (Letter of Credit) is the familiar word in apparel industry. L/C set up is the work
of merchandising section in garment factory. A merchandiser should have clear
concept on letter of credit. Letter of Credit (L/C) also known as Documentary Credit is a
widely used term to make payment secure in domestic and international trade.

Letter of Credit
The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for
Documentary
Credit
(UCPDC)
defines
L/C
as:
"An arrangement, however named or described, whereby bank (the Issuing bank) acting
at the request and on the instructions of a customer (the Applicant) or on its own
behalf.

Actually, LC is such kinds of commercial letter which a bank issue on behalf of foreign
seller (exporter) according to the direction of the (importers) purchasers. The
documents shown under are known as export documents form the importers side.
These are:
1.

Bill of exchange

2.

Bill of lading

3.

Airway bill / Railway receipt

4.

Commercial invoice

5.

Insurance policy

6.

Certificate of origin

7.

Packing list

8.

Bill of entry

A short description of above terms is given below:

Bill of exchange:
The bill of exchange is that particular instrument through which payment is effected in
trade deals internal and international. The payment for the goods is received by the
seller through the medium of a bill of exchange drawn on the buyer for the amount
depending on the contract. It is a negotiable instrument. There are five main parties
involved in a bill of exchange. They are :

Drawer

Drawee

Payee

Endorser

Endorsee

Bill of lading : A bill lading is a document of title to goods entitling the holder to receive
the goods as beneficiary or endorsee and it is with the help of this document on receipt
from the exporter that the importer takes possession of the goods from the carrying
vessel
at
the
port
of
destination.
Airway bill / Railway receipt : When goods to be transported are small in bulk or

requiring speedy delivery or those are perishable in nature on the deal is in between the
neighboring countries then mode of transports other than shipping may be resorted to
far the carriage of the goods Airways bill / Railway receipt take place of Bill of lading
depending
on
the
nature
of
the
carrier.
Commercial invoice : It is the sellers bill for the merchandise. It contains a description
of goods, the price per unit at a particular location, total value of the goods, packing
specifications, terms of sale, letter of credit, bill of lading number etc. There is no
standard form far a commercial invoice. Each exporter designs his own commercial
invoice form. The invoice is made out by the seller under his signature in the name of
the buyer and must be submitted in a set of at least 3 copies. Its main purpose is to
check whether the appropriate goods have been shipped and also that their unit price,
total value, marking on the package etc. are consistent with those given in other
documents.
Insurance policy : In the international trade insurance policy is a must to cover the risk
of loss on consignments while they are on seas, roads, airways. The insurance is the
responsibility of the buyers (consignee) under FAS, FOB and C&F contracts and of the
seller (consignor) under CIF contract. The policy must be of the type as specified in the
relative contract / credit. The policy would be for the value of CIF price plus 10 (ten)
percent to cover the expenses and that is required to be obtained in the same currency
as that of the credit and dated not later than the date of shipment with claims* being
payable at the destination. It must be properly stamped. Like a bill lading it must be
negotiable
and
be
endorsed
where
it
is
payable
to
order.
Certificate of origin : This is a certificate issued by a recognized authority in exporting
country certifying the country of origin of the goods. It is usually by the Chambers of
commerce. Some times, it is certified by local consul or Trade Representative of the
importing
country
as
per
terms
of
the
credit.
Packing list : The exporter must prepare an accurate packing list showing item by item,
the contents of the consignment to enable the receiver of the shipment to check the
contents of the goods, number and marks of the package, quality, per package net
weight,
gross
weight,
measurement
etc.
(viii) Weightment and Measurement: Issued by recognized authority (like chambers of
commerce and industry) in exporting country certifying correct weightment and
measurement
of
the
goods
exported.
Bill of entry : A bill of entry is a document which contain the particulars of the imported
goods as well as the amount of customs duty payable.
The exporter submit the following papers/documents to the Negotiating bank :
1.

Bill of exchange / Draft.

2.

Bill of lading.

3.

Airway bill / Railway receipt.

4.

Commercial invoice.

5.

Insurance policy.

6.

Certificate of origin.

7.

Packing list.

8.

Weightment & measurement list.

9.

Other etc.

The negotiating bank after received the above documents / papers then this bank
scrutiny the documents. The negotiating bank sends the original shipping documents to
the L/C opening bank and keeping the second copy with the negotiating bank.

Types

of

Letter

of

Credit:

An Import/Export Letter of Credit (popularly called Master LC) is used in international

trade between buyers and sellers of different countries but Back to Back letter of credit
can be used in both local and international trade. Let us get introduced with different
types
of
letters
of
credit
used
in
apparel
export
business:

Import/Export

Letter

of

Credit

The same credit is termed as Import Letter of Credit or Export Letter of Credit. It
depends on whose perspective it is being considered. For the importer it is termed as
Import Letter of Credit and for the exporter it is termed Export Letter of Credit.

Revolving

Letter

of

Credit

(L/C)

Revolving letters of credit were a tool created to allow companies conducting regular
business to issue a letter of credit that could roll-over without the company having to
reapply, thus enabling business flow to continue without interruption as long as the
terms and conditions, quantities, and other transaction details did not change.

Revocable

Letter

of

Credit

Without the authentication of the seller/exporter(beneficiary), buyer/importer (applicant)

can cancel or make any amendment of this type of Letter of Credit through the issuing
Bank. This type of letter of credit is totally manipulated by the buyer. None accepts this
type
of
letter
of
credit
these
days.

Irrevocable

Letter

of

Credit

Without the authentication of the seller/exporter(beneficiary), buyer/importer (applicant)

cannot cancel or make any amendment of this type of Letter of Credit through the
issuing Bank. It can only be cancelled without the authentication of the seller/exporter
(beneficiary) if it is expired. Exporters always prefer this type of letter of credit.

Transferable

Letter

of

Credit

Transferable Letter of Credit is required when the exporter is middleman or agent (not
the actual supplier) of the goods but buyer finds it valuable to work with this type of
agent/middleman. This is also fact that sometimes agent/middleman does not want the
buyer and supplier know each other. In this type of Credit, the exporter has the right to
transfer the credit to one or more subsequent beneficiaries to procure the goods and
arrange them to be sent to the buyer. Usually buying houses prefer this type of letter of
credit.

Nontransferable
The

credit

cannot

be

Letter
transferred

Confirmed

to

anyone

Letter

of

Credit

the

exporter/beneficiary.

by

of

Credit

An additional confirmation or guarantee that commits to payment of the letter of credit. A

confirmed letter of credit is typically used when the issuing bank of the letter of credit
may have questionable creditworthiness and the seller seeks to get a second guarantee
to
assure
payment.

Unconfirmed

Letter

of

Credit

This type of letter of credit, does not acquire the other bank's confirmation.

Sight

Credit

and

Usance

Credit

(L/C)

Sight credit states that the payments would be made by the issuing bank at sight, on
demand or on presentation. In case of usance credit, As per agreement by both of the
exporter/beneficiary and importer/applicant this type of letter of credit requires an
indicated duration for payment instead of getting paid immediately after the valid
documents are checked. By this time importer/buyer can take the opportunity to arrange
money
selling
the
goods.

At

Sight

Letter

of

Credit

As mentioned in this type of letter of credit, payment is made to the exporter/beneficiary

immediately upon presentation of the correct document. Apparel exporter prefer this
type
of
letter
of
credit.

Red

Clause

Letter

of

Credit

This is the specific type of letter of credit that carries a provision (traditionally written or
typed in red ink) which allows a exporter/beneficiary to draw up to a fixed sum from the
advising or paying-bank, in advance of the shipment or before presenting the prescribed
documents.

Back

to

Back

Letter

of

Credit

The Back to Back Letter of Credit (sometimes referred to as the Baby or Slave Letter of
Credit) is issued on the strength of the Master Letter of Credit (Master LC). Back to

Back Letter of Credit is issued by the exporters bank (advising bank) to the supplier to
procure raw materials. Permission of the ultimate buyer or that of the issuing bank is not
required
to
issue
a
back
to
back
letter
of
credit.

Standby

Letter

of

Credit

(L/C)

The standby letter of credit is very much similar in nature to a bank guarantee. The main
objective of issuing such a credit is to secure bank loans. Standby credits are usually
issued by the applicants bank in the applicants country and advised to the beneficiary
by
a
bank
in
the
beneficiarys
country.

Parties

to

Letters

of

Credit

Applicant (Opener): Applicant which is also referred to as account party is normally a

buyer or customer of the goods, who has to make payment to beneficiary. LC is initiated
and issued at his request and on the basis of his instructions.
Issuing Bank (Opening Bank): The issuing bank is the one which create a letter of
credit and takes the responsibility to make the payments on receipt of the documents
from the beneficiary or through their banker. The payments have to be made to the
beneficiary within seven working days from the date of receipt of documents at their
end, provided the documents are in accordance with the terms and conditions of the
letter of credit. If the documents are discrepant one, the rejection thereof to be
communicated within seven working days from the date of receipt of documents at their
end.
Beneficiary: Beneficiary is normally stands for a seller of the goods, who has to receive
payment from the applicant. A credit is issued in his favour to enable him or his agent to
obtain payment on surrender of stipulated document and comply with the term and
conditions
of
the
L/C.
If L/C is a transferable one and he transfers the credit to another party, then he is
referred
to
as
the
first
or
original
beneficiary.
Advising Bank: An Advising Bank provides advice to the beneficiary and takes the
responsibility for sending the documents to the issuing bank and is normally located in
the
country
of
the
beneficiary.
Confirming Bank: Confirming bank adds its guarantee to the credit opened by another
bank, thereby undertaking the responsibility of payment/negotiation acceptance under
the credit, in additional to that of the issuing bank. Confirming bank play an important
role where the exporter is not satisfied with the undertaking of only the issuing bank.
Negotiating Bank: The Negotiating Bank is the bank who negotiates the documents
submitted to them by the beneficiary under the credit either advised through them or
restricted to them for negotiation. On negotiation of the documents they will claim the
reimbursement under the credit and makes the payment to the beneficiary provided the
documents submitted are in accordance with the terms and conditions of the letters of
credit.
Reimbursing Bank: Reimbursing Bank is the bank authorized to honor the

reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by

the negotiating bank. It is normally the bank with which issuing bank has an account
from which payment has to be made.
Second Beneficiary: Second Beneficiary is the person who represents the first or
original Beneficiary of credit in his absence. In this case, the credits belonging to the
original beneficiary is transferable. The rights of the transferee are subject to terms of
transfer.
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A Letter of Credit is a type of Documentary Credit governed byUCP600

(Uniform Customs and Practice)..
ICC defines a Letter of Credit as
A letter of credit is a promise by a bank on behalf of the buyer
(customer/importer) to pay the seller (beneficiary/exporter) a specified
sum in the agreed currency, provided that the seller submits the required
documents by a predetermined deadline.