Letters of credit authorize the recipient or beneficiary to draw funds up to a total specified in the letter, from the issuer's bank.
The letter may be used for transactions involving distance between the customer and the beneficiary. For instance, if a vendor seeks to buy something from a seller across the country, a letter of credit may be issued to assure the seller that he will be paid.
Revocable and Irrevocable
A revocable letter of credit can be cancelled or amended by the issuing bank without any notification to or the consent of the beneficiary. This type of letter of credit is rarely used because it offers no real assurance to the beneficiary that the letter will, in fact, be honored.
Irrevocable letters of credit may not be changed in any way. The letter guarantees the beneficiary that, as long as he conforms to all of terms of the letter for receiving funds, the bank will issue the funds.
A transferable letter of credit is used to transfer the rights and obligations of the beneficiary to a third party. For instance, a vendor who is unable, for some reason, to purchase merchandise from the manufacturer and carry out the sale, may name the manufacturer the beneficiary of a letter of credit. The vendor, in effect, uses the buyer's letter of credit to guarantee the manufacturer that he will be paid.
Confirmed and Unconfirmed
An unconfirmed letter of credit is issued, usually by a foreign bank, with no verification by a bank in the beneficiary's country. Like the revocable letter of credit, this type of letter offers the beneficiary no real protection if the foreign buyer's bank fails to honor the buyer's commitment.
Unlike the unconfirmed letter, a confirmed letter adds protection for the seller because the foreign bank is verified and the funds covered by the letter of credit are guaranteed by a bank in the beneficiary's own country.
Assignment of Proceeds
Like a transferable letter of credit, an assignment of proceeds is a letter of credit that allows a third party to be paid in whole or in part. The assignment of proceeds does not, however, transfer any goods, rights or titles to the third party.
A revolving letter of credit is recyclable. The letter may be used several times, for several identical transactions occurring at different times. If a vendor buys a product every month from the same seller, purchasing the same amount of product at the same price, a revolving letter of credit means that a new letter for each transaction is not needed.
A standby letter of credit is a form of backup funding.
If the beneficiary is not paid by the buyer, he may withdraw the necessary funds from the buyer's bank using the standby letter of credit.
The bank is obligated to pay even if the beneficiary and the buyer are involved in a dispute over the transaction.
- Photo Credit bank image by Pefkos from Fotolia.com