Letter of Credit: Meaning & Types
A letter of credit (L/C) is a type of “documentary credit” or a “non-fund based credit”. It is a document issued by a bank or financial institution at the request of a buyer whereby the bank or financial institution gives assurance of payment to a seller if the terms and conditions specified in the document are fulfilled. This means that Letter of Credit is a promise made by Bank to pay to exporter / seller on behalf of importer / buyer. The seller receives the payment only when all the requirements specified in the L/C are met including the documents, delivery dates, product specification, etc.
Thus, a Letter of Credit has three parties:
- Buyer / Importer: Also known as Opener, as he opens the credit
- Bank / Financial Institution: Also known as Issuer, as it opens the letter of credit
- Seller / Exporter : Also known as beneficiary as credit is opened in favour of him.
Types of Letter of Credit
There are several types of Letter of Credit on the basis of various levels of security they grant to the beneficiary (seller/exporter).
Irrevocable Letter of Credit
An irrevocable Letter of Credit cannot be modified or cancelled without the agreement of all the three parties.
Revocable Letter of Credit
A revocable letter of credit may be modified or even cancelled by the issuing bank at any time and without notice to the beneficiary. Such L/Cs are rare now a days as they give maximum flexibility to the buyers but involve risk to the seller.
Confirmed Irrevocable Letter of Credit
In a confirmed Irrevocable L/C, another bank (called Confirming Bank) is yet more party which obliges itself to honour the L/C in same manner as issuing bank. Such L/C is used to back up the credit standing of the issuing bank and to mitigate the risk in foreign trade by replacing foreign bank risk by domestic bank risk.
Unconfirmed Irrevocable Letter of Credit
In Unconfirmed Irrevocable Letter of Credit, a seller’s domestic bank (called advisory bank) acts as agent of the issuing bank but without assuming any responsibility towards the beneficiary. The role of advisory bank here is limited to taking care of the authenticity of the issuing bank and documentary credit.
Revolving Letter of Credit
A revolving Letter of Credit is used in the case of regular business transactions between the buyer and the seller. The L/C is issued only once but remains valid for a stated period of time for a number of transactions without issuing another L/C. The Revolving L/C can be either revocable or irrevocable.
A Letter of Credit ensures the seller that his payment will be made as long as the services are performed (dispatch of goods in case of foreign trade). Thus, Letter of Credit serves as a guarantee to the seller that he or she will be paid as agreed. Letter of Credit is an instrument of trade financing.