Types of Letters of Credit

There are several types of Letters of Credit, all of which International Funding Partners provide to clients. These include:

Documentary; Merchandise, Commercial, Trade

The majority of Letters of Credit issued are in payment for goods in shipment or current services performed. Payment is normally made against documents for goods shipped. (Article 1&2, UCP 600).

Standby

Normally, this type of Letter of Credit functions like a guarantee. This type of credit can be drawn against only upon performance of service or financial obligation default. It is a definite undertaking of the issuing bank, financial institution, or issuer of the Letter of Credit. Similar to commercial Letters of Credit, standbys are governed by the International Standby Practices 1998 (ISP98).

Unconfirmed

Bears only the obligation of the issuing bank, financial institution or issuer of financial instruments. The beneficiary should look to the credit worthiness of only the financial institution, and not to any intermediary (Article 9, UCP 600).

Confirmed

This is a credit in which a second obligation is added to the Letter of Credit by another bank or financial institution. (Article 9, UCP 600).

Sight

Payment is at sight, which means that the drafts and documents are honoured, if in order, by making payment without delay

Time, Usance

The draft honoured by the acceptance is for payment at a future date. Payment is delayed until the maturity of the draft.

Transferable Credit

Transferable credit can be transferred by the original beneficiary to one or more other parties. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and wants to transfer all or part of his rights to the actual supplier (Article 48, UCP 600)

Back To Back Letters Of Credit

Funding against an incoming letter of credit can be trickier than it ought to be in today's banking environment. A Documentary Letter of Credit (DLC) can only be cashed upon presentation of the required shipping documents and inspection reports (if needed). Before goods ship, the DLC has potential value, but it isn't fungible, or cashable YET. Your supplier wants to be paid in order to produce and ship, but you won't be able to convert that DLC into cash until your supplier ships the product. If you have received a non-transferable letter of credit in payment, you are going to need a bridging mechanism to pay your supplier to get your deal all the way home.

The back to back letter of credit is your bridging mechanism, enabling you to finance your order against the incoming Letter of Credit. A Letter of Credit is issued to your supplier, with payment terms that mirror the terms in the incoming Letter of Credit, same shipping documents, same inspection or other requirements.

There is a second type of businessman for whom the back to back Letter of Credit is a very useful tool: the broker or middleman who knows his industry well enough that he is ready to act as principal. As long as he is still a broker, he always faces the risk that his customers will try and circumvent him. And his earnings are capped by commissions his customers are willing to pay. When the middleman has enough capital to put up to meet the capital requirements for back to back Letter of Credit finance, he can leave the brokering rat race. When he acts as principal, he no longer has to worry about price transparency or the visibility of buyer to supplier and vice versa.

Products Compared

Comparison of various methods of payment

Method Goods Available Time of Payment Risk to Exporter Risk to Importer
Cash in advance After Payment Before shipment Very Low Maximum – Relies on exporter to ship goods as ordered
Letter of Credit
*Confirmed
*Unconfirmed
(Advised)
After Payment When documents are available at shipment Very Low Assured of quantity and quality of shipment if inspection is required
Documentary Collection, Sight Draft documents against Payment After Payment On Presentation or draft to importer If draft unpaid, goods must be returned or disposed of, usually at loss Assured of quantity, also quality, if goods are inspected before shipment
Documentary Collection Time Draft Documents against Acceptance Before Payment On maturity of draft Relies on importer to pay draft Minimal – can check for quantity and quality before payment
Consignment Before payment, exporter retains title until goods are sold or used After use; inventory and warehousing cost to exporter Substantial risk unless through foreign branch of subsidiary Very Low
Open Account Before payment As agreed Relies on importer to pay account as agreed – complete risk Very Low