Types and Uses of Letters of Credit

peach swirls

There are various types of Letters of Credit/Documentary Credits which have, over time, been developed to satisfy certain needs of the Buyer and Seller.  Each type of Credit carries primary characteristics and operational risks that need to be understood prior to the Credit being accepted.

Although it is possible to categorise Letters of Credit into types, it should be noted that the terms and conditions of one Credit could include the terms of another type.  All Credits should be read as whole documents.

In addition, although the banking world has accepted the rules and regulations of UCP 600, there are banks which, due to tradition, lack of initiative or plain laziness to change their procedures, will revert back to old forms and ways of opening Credits.  It can be difficult to get this changed at the amendment stage.

The following descriptions constitute some of the more likely forms of Credits that can be issued through the banking system.

Irrevocable Credit
In previous UCP, for example 400 and 500, it was possible for Applicants to ask for Revocable Credits.  These are Letters of Credit that could be revoked/cancelled after issuance.

However, under UCP 600 (Article 2) a Credit is now always deemed to be Irrevocable even if not stated in the Credit itself.  This means that once a Credit has been issued, it can not be revoked for any reason.  All types of Credit under UCP 600, therefore, are Irrevocable.

Confirmed Credits
A confirmation of a Credit by another bank (the Confirming Bank) upon the authorisation of the Issuing Bank, constitutes a definite undertaking, in addition to the undertaking of the Issuing Bank, that provided the stipulated documents are presented to the Confirming Bank and that all terms and conditions are complied with, the Confirming Bank will honour its obligations under the Credit.

The Confirming Bank is usually based in the country of export and provides additional security to the Beneficiary. However, such security comes with a price and sometimes confirmations can be costly. In some countries the request for a Confirmed Credit can be seen as a slur on their national character and so they might refuse to allow a Credit to be Confirmed.

The rules regarding the responsibilities and actions of a Confirming bank is detailed in UCP 600 under Article 8.

Advance Payment Credits
These are also known as Red Clause Credits and allow the beneficiary to claim part of the value of the Credit issued as a pre shipment advance.  Historically this clause appeared in bold red type in order to draw attention of the special advance.

Such Credits are unusual due banking laws in a number of countries disallowing this type of financing and also because in some circumstances it can trigger Money Laundering regulations.

This type of Credit is often surrounded by a series of strict conditions, a major one being that the Applicant and/or Issuing Bank often requires a performance guarantee to be issued by the Beneficiary.  In such circumstances the benefit of the advance payment is seriously compromised and can offer more risks than benefits.

Revolving Credits
Revolving Credits are usually only issued when the Beneficiary and Applicant have a long standing trading agreement.  This type of Credit allows the amount available on the Credit to be reinstated, usually without any specific amendment, thus saving on bank charges and overhead costs as goods are shipped and documents presented.

Such reinstatements can be dependent either upon time (a specific amount is allowed to be drawn within each specific period as stipulated in the credit) or upon value.  Usually such Credits will specifically exclude the provisions of Article 32 UCP 600, which refers to Instalment shipments.

Instalment shipments/drawings
Instalment shipments are fundamentally different from Revolving Credits and as such Article 32 is not intended to relate to Revolving Credits.  Instalment shipments refers to a Credit where shipment by instalments within stated periods is agreed specifically between Beneficiary and Applicant in order to meet specific delivery dates.  It is for this reason that Article 32 provides for the cancellation of instalments not shipped in accordance with the Credit.  Any reinstatement of an instalment requires a specific amendment, unlike a Revolving Credit.

Evergreen and Renewable Credits
These types of Credit are usually used with Standby Credits and are available for longer periods, in trades where the liability under the transaction may not be easily determined or the extent of the liability quantifiable.  One of the aspects of this type of Credit is that they can only be cancelled or amended provided notice is given by the Applicant to the Beneficiary well in advance.

Transferable Credits
These types of Credit have been developed to enable Beneficiary’s to use the funds within the Credit itself to finance purchases of goods from their suppliers, where required.

Under a Transferable Credit the Applicant instructs its bank to issue a Credit in transferable form in favour of the Beneficiary (who is known as the first Beneficiary) from whom the goods are purchased. This enables the first Beneficiary to request the bank where the credit is available, to transfer the credit in whole or in part to the first Beneficiary’s supplier (who is known as the second Beneficiary).

Article 38 of UCP 600 refers to Transferable Credits.

Standby Letter of Credit
Traditional Letters of Credit provide payment to the Beneficiary once the goods have been shipped and the correct documentation has been provided to the bank.

Standby Letters of Credit are issued in favour of the Beneficiary to ensure that if payment is not received under some other pre-agreed method, it will be made under the Standby Credit upon the Beneficiary fulfilling his part of the agreement.

To this extent the Standby acts as a form of guarantee. The rules governing the use of Standby Letters of Credit are known as ISP 98.

This is the seventh article in the series of How to Get Paid using Letters of Credit.

Maria Narancic from Point to Point Export Services is an independent international trade adviser who assists organisations world wide with their international trade projects, documentation, Documentary Credits and import/export training. She is based in the United Kingdom. If you require any further assistance with the matters mentioned above, please do contact us by e-mail on info@point-point.com or to access other articles on International Trade matters please do check out our website at www.point-point.com.

Leave a Reply

Protected by WP Anti Spam