International Trade (Intl Trade) 101: Payment Methods - Letters of Credit Definition, Parties Types Irrevocable Confirmed Unconfirmed Revolving Transferable Back-to-Back Standby LC

What This Is

A Letter of Credit (LC) is a payment guarantee issued by a bank on behalf of a buyer to a seller, ensuring payment for goods or services once specific conditions are met. This concept is crucial in international trade as it mitigates payment risks and provides a secure payment mechanism for cross-border transactions. For instance, a Chinese exporter, Shanghai Electronics, sells electronic components to a US importer, Tech Solutions, under an LC. The LC specifies that payment will be made upon presentation of a clean bill of lading, commercial invoice, and other required documents. If the documents are found to be in order, the US bank will pay the Chinese exporter, ensuring timely payment and reducing the risk of non-payment.

Key Terms & Rules

• Irrevocable LC: Cannot be cancelled or amended without the consent of all parties involved. This type of LC provides the highest level of security for the seller.
• Confirmed LC: An irrevocable LC that is guaranteed by a second bank, typically the buyer's bank, in the seller's country. This type of LC provides additional security for the seller.
• Unconfirmed LC: An irrevocable LC that is not guaranteed by a second bank. This type of LC is less secure than a confirmed LC.
• Revolving LC: An LC that can be renewed or extended for a specified period, allowing the seller to continue receiving payments for goods or services.
• Transferable LC: An LC that can be transferred to another beneficiary, allowing the seller to assign the LC to a third party.
• Back-to-Back LC: A type of LC that is issued by a bank to a second beneficiary, typically the original seller, for the purchase of goods or services from a third party.
• Standby LC: A type of LC that is issued by a bank to a beneficiary, typically a seller, to guarantee payment for goods or services in the event of a default.
• UCP 600: Uniform Customs and Practice for Documentary Credits, which governs LC transactions globally and provides a standardized framework for LC operations.
• URC 522: Uniform Rules for Bank-to-Bank Reimbursements, which governs the reimbursement process for LC transactions.
• Beneficiary: The seller or beneficiary of the LC, who receives payment upon presentation of the required documents.
• Applicant: The buyer or applicant who requests the LC from their bank.
• Issuing Bank: The bank that issues the LC on behalf of the applicant.
• Advising Bank: The bank that advises the beneficiary of the LC.
• Confirming Bank: The bank that guarantees the LC on behalf of the issuing bank.

Step-by-Step Process

1. Applying for an LC: The applicant (buyer) submits a request to their bank to issue an LC, providing details of the transaction, including the amount, currency, and payment terms.
2. Issuing the LC: The issuing bank verifies the applicant's creditworthiness and issues the LC, which is then sent to the advising bank.
3. Advising the Beneficiary: The advising bank advises the beneficiary (seller) of the LC, providing them with the details of the transaction.
4. Presenting Documents: The beneficiary presents the required documents, including the commercial invoice, bill of lading, and other supporting documents, to the advising bank.
5. Verifying Documents: The advising bank verifies the documents to ensure they meet the requirements specified in the LC.
6. Reimbursing the Issuing Bank: If the documents are found to be in order, the advising bank reimburses the issuing bank, which then pays the beneficiary.

Common Mistakes

• Mistake: Confusing CIF (Cost, Insurance, and Freight) with CIP (Carriage and Insurance Paid To).
• Correction: CIF includes the cost of freight, while CIP includes the cost of carriage and insurance.
• Example: A Chinese exporter sells goods to a US importer under a CIF contract. The US importer is responsible for arranging the carriage and insurance, while the Chinese exporter is responsible for the cost of freight.
• Mistake: Assuming "open account" is risk-free.
• Correction: Open account transactions do not involve a letter of credit or a bank guarantee, leaving the seller exposed to payment risks.
• Example: A US importer purchases goods from a Chinese exporter on an open account basis. If the US importer fails to pay, the Chinese exporter may not receive payment.
• Mistake: Misusing "free on board" with air freight.
• Correction: Free on board (FOB) is typically used with sea or inland waterway transportation, while free at airport (FAA) is used with air transportation.
• Example: A Chinese exporter sells goods to a US importer under a FOB contract, but the goods are transported by air. The Chinese exporter is responsible for delivering the goods to the airport, while the US importer is responsible for arranging the carriage from the airport to their destination.

Exam / Certification Tips

• Common question patterns: LC transactions, document requirements, and payment terms.
• Tricky distinctions: Confirmed vs unconfirmed LC, DPU (Destination Port of Unloading) vs DAT (Destination Arrival Terminal), and FOB vs FCA (Free Carrier).
• Memory aids: Use mnemonics to remember key terms and concepts, such as "UCP 600" for Uniform Customs and Practice for Documentary Credits.
• Focus on key concepts: Understand the purpose and function of an LC, as well as the roles and responsibilities of each party involved.

Quick Practice Scenario

Scenario: A Chinese exporter sells goods to a US importer under a confirmed LC. The LC specifies that payment will be made upon presentation of a clean bill of lading and commercial invoice. However, the US importer receives the documents with a 2-day delay. Which LC discrepancy arises?

Answer: Delayed presentation of documents.

Explanation: The US importer received the documents with a 2-day delay, which is a discrepancy in the presentation of documents.

Last-Minute Cram Sheet

• LC: A payment guarantee issued by a bank on behalf of a buyer to a seller.
• Irrevocable LC: Cannot be cancelled or amended without the consent of all parties involved.
• Confirmed LC: An irrevocable LC that is guaranteed by a second bank.
• UCP 600: Uniform Customs and Practice for Documentary Credits.
• Beneficiary: The seller or beneficiary of the LC.
• Applicant: The buyer or applicant who requests the LC from their bank.
• Issuing Bank: The bank that issues the LC on behalf of the applicant.
• Advising Bank: The bank that advises the beneficiary of the LC.
• Confirming Bank: The bank that guarantees the LC on behalf of the issuing bank.
• Under FOB, risk transfers when goods are on board the vessel – not at the port gate or on the dock.
• A confirmed LC is not the same as a guaranteed LC.
• The beneficiary is responsible for presenting the required documents to the advising bank.
• The issuing bank is responsible for verifying the applicant's creditworthiness before issuing the LC.