Classification of Letters of Credit

From Supply Chain Management Encyclopedia

Jump to: navigation, search

Russian: Классификация аккредитивов

There is a multitude of forms/types of Letters of Credit. Letters of credit may be classified[1], according to whether the issuing bank may or may not rescind its obligation to the beneficiary. When a bank agrees to honor the drafts of the exporter within a certain period of time the instrument is called an irrevocable letter of credit, while a revocable credit may be canceled at any time by the bank. Letters of credit are frequently transmitted to the beneficiary not directly by the issuing bank, but indirectly through a second notifying bank[2]. If the latter institution adds its guaranty to the obligation of the former, the letter of credit is then said to be confirmed, otherwise it is considered unconfirmed. Banks may therefore give beneficiaries the following kinds of credits:

  • (1) irrevocable by issuer and confirmed by notifier,
  • (2) irrevocable by issuer and unconfirmed by notifier,
  • (3) revocable by issuer and unconfirmed by notifier.

A revocable confirmed letter of credit is of course impossible in actual practice, for a notifying bank would under no condition add its confirmation to an instrument which could be nullified by the issuer at will. Letters of credit may also be grouped according to the currency in which they are issued. Before the war the letter of credit drawn in sterling was the standard instrument of international commerce, but in recent years the dollar credit has been growing in favor, not alone among American merchants, but also with foreign firms.

Therefore, there could be different classification criteria. However, we consider as the most reasonable and closest to sense and scope of the ICC Uniform Customs and Practice for Documentary Credits (UCP 600)[3] two-dimensional (forms[4] and types[5]) classification system coined by Credit Suisse.The various forms of letters of credit are distinguished by the agreed level of security and the point in time at which risk is assumed.Letters of credit are distinguished by their different types of use.

Forms and Types of Letters of Credit

  • In the case of an unconfirmed letter of credit, the correspondent bank merely notifies the seller that a letter of credit has been opened. In this case, it makes no promise to pay and is therefore not required to honor documents presented by the seller. As a result, the seller may rely exclusively on the issuing bank (letter of credit bank) and therefore bears the collection risk of the issuing bank and the country risk[6] – according to their domicile – as well as the transfer risk.
  • If the correspondent bank confirms the letter credit (on behalf of the issuing bank), then it is committing itself towards the seller to honor documents that are in compliance with the documentary credit terms and presented on time. In this case, the seller receives not only an obligation by the issuing bank but also a legally equivalent and independent promise of payment on the part of the correspondent bank. The seller then bears the collection risk of the confirming bank and, if this bank is not domiciled in his country, the corresponding country risk – according to its domicile – as well as the transfer risk.
  • All letters of credit subject to the current "Uniform Customs and Practice for Documentary Credits" (UCP 600), which is effectively the norm nowadays, are regarded as irrevocable. It is possible in theory to open a revocable letter of credit, but this is no longer done in practice for various reasons (difficult wording/insufficient security [revocation]).
  • An irrevocable letter of credit is a firm commitment by the issuing bank to make payment if the documentary credit conditions are fulfilled. It may not be amended or canceled without the consent of the seller and all obligated banks.
  • If the seller wishes to amend or cancel individual conditions of the letter of credit, then he must ask the buyer to issue an instruction to the issuing bank in this respect.
  • Under a sight letter of credit, payment is made to the seller immediately after the required documents have been submitted to the authorized bank, provided the conditions in the letter of credit have been met. Banks are, however, allowed a reasonable period of time for checking purposes (not more than five working days after they receive the documents).
Deferred Payment
  • In the case of a letter of credit with deferred payment, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the letter of credit.
  • In the Far East, this kind of documentary credit is also known as a "usance L/C."[7]
  • In the case of an acceptance credit, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the letter of credit.
  • The seller can request a discount from the bank that accepted the bill of exchange, or from another bank, and thus draw the amount of the bill minus the discount at any time after the documents have been submitted.
Negotiable Credit
  • Under UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision, article 2) negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.
  • Unfortunately, the term "negotiable credit" is understood and applied in different ways in different parts of the world.
Transferable L/C
  • Transferable letters of credit are particularly well adapted to the requirements of international trade. They allow an intermediary to transfer a letter of credit to a supplier, thus enabling the intermediary to reduce the extent to which it uses its own funds to process business transactions.
Standby L/C
  • Standby letters of credit are similar to guarantees. Due to their documentary nature, they fall under the UCP (Uniform Customs and Practice for Documentary Credits). Standby letters of credit can also be issued under ISP98 (International Standby Practices).
  • If the guaranteed service/payment is not provided, the seller can invoke the bank's obligation to pay by submitting, together with any other documents that the letter of credit might require, a declaration stating that the letter of credit customer has failed to meet his obligations/payment
Revolving L/C
  • If the buyer requests partial deliveries of the ordered goods at specific intervals (contract for delivery by installments), payment can be made under the terms of a revolving letter of credit that covers the value of each consecutive installment. The bank is normally liable for the total value of all agreed partial deliveries.
  • However, the second partial payment is not effective until the first installment has been paid, and so forth.
Red Clause L/C
  • In the case of a red clause credit (letter of credit with advance payment), the seller can request an advance for an agreed amount (defined in the terms and conditions of the letter of credit) from the correspondent bank. This advance is basically intended to finance the manufacture or purchase of the goods to be delivered under the letter of credit. The advance is normally paid against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires.
Green Clause L/C
  • Unlike the red clause letter of credit, in the case of a green clause letter of credit, the advance is normally paid not only against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires, but also against receipt of an additional document providing proof that the goods to be shipped have been warehoused.


  2. Notifying Bank - A bank in a foreign country to which another bank in the domestic country sends a letter of credit on behalf of a client. The notifying bank honors the letter of credit and transfers requested funds to the client. A notifying bank is also called an advising bank. -
  3. ICC Uniform Customs and Practice for Documentary Credits (UCP 600) -
  4. Forms of Letters of Credit -
  5. Types of Letters of Credit -
  6. A collection of risks associated with investing in a foreign country. These risks include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of capital being locked up or frozen by government action. Country risk varies from one country to the next. Some countries have high enough risk to discourage much foreign investment. -
  7. A usance letter of credit is a financial instrument that sets the terms and conditions for the payment of a debt at a specific date in the future. Typically, the terms and conditions found within the letter of credit will cover details such as the mode of payment used to settle the debt, the total amount owed at the time of settlement, and the name of the beneficiary. It is not unusual for the letter of credit to be accompanied by supporting documents, such as an invoice for the total amount due for payment, and even a time draft that can be processed on the agreed-upon date. While a usance letter of credit may carry a due date of any duration agreeable to the parties concerned, documents of this type usually include a date that is no more than six months from the date that the letter of credit is issued. This makes the letter of credit a useful financial tool for meeting short-term needs, allowing the recipient of the letter to obtain the credit needed to finance a specific project and hopefully generate enough return from that project to settle the total amount due within the time frame allotted. As with most types of debt instruments, usance letters can be settled in advance if the recipient is able to do so, often with no types of penalties involved. -
Personal tools
Our Partners