Most Common Types of Letters of Credit
Below are some of the more common types of letters of credit. The list is not meant to be exhaustive.
Irrevocable Letter of Credit
In terms of letters of credit, irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed. It cannot be modified or revoked without the agreement of all parties involved, offering a high level of security for both the buyer and the seller.
Revocable Letter of Credit
Alternatively, a revocable letter of credit allows the issuing bank to modify or cancel the credit without the consent of the beneficiary. Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them.1
Confirmed Letter of Credit
A confirmed letter of credit involves the addition of a confirmation by a bank other than the issuing bank, typically the seller's bank. This confirmation serves as a secondary guarantee of payment. This adds an extra layer of security for the seller. The seller can rely not only on the issuing bank's credit but also on the assurance of payment from the confirming bank. This type might be most suitable usually when the beneficiary does not trust the other party's bank.2
Unconfirmed Letter of Credit
An unconfirmed letter of credit is only guaranteed by the issuing bank and does not involve confirmation from another bank. While this type of letter may be simpler and less expensive for the buyer, it offers less security for the seller. The seller then has to rely solely on the creditworthiness of the issuing bank which may not be sufficient, especially if the seller is unfamiliar with other the other parties.
Standby Letter of Credit
A standby letters of credit work slightly different than most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange. They are commonly used in various scenarios, including construction projects, international trade, and commercial transactions.
Transferable Letter of Credit
A transferable letter of credit allows the seller to transfer all or part of the credit to another party. This flexibility can be beneficial when the seller is unable to fulfill the entire order themselves or when subcontracting certain aspects of the transaction. Transferable letters of credit streamline the payment process and facilitate complex transactions by allowing multiple parties to be involved, such as a small business supplier or construction subcontractor.
Revolving Letter of Credit
A revolving letter of credit is used for multiple shipments over a specified period, allowing the buyer to make multiple drawdowns up to a predetermined limit. This type of letter is useful for ongoing business relationships where there are frequent transactions between the buyer and the seller. An important part here is to realize each party has an ongoing, familiar relationship meaning there is a certain standard of higher trust involved. Revolving letters of credit simplify the payment process by eliminating the need to open a new credit for each shipment meaning they may be more convenient and efficient.
Red Clause Letter of Credit
Red clause letters of credit include a special clause that allow the seller to receive partial payment in advance of shipment. This advance payment, often referred to as a "red clause advance," can be used by the seller to finance the production or purchase of goods for export. This type of letter of credit can give financial assistance to the seller, particularly in situations where they require funds upfront to fulfill the order. For example, consider scenarios where the seller may need to buy specific, rare, expensive raw materials for production of a custom order.