A letter of credit is a negotiable instrument, under which the issuing bank undertakes to pay the seller or the bank nominated by the seller, a certain sum of money on a certain date or certain event.
In cross border transactions, the bank will usually require a pledge of securities or cash as collateral for issuing a letter of credit, to make sure that if it is required to pay the seller under the terms of the letter of credit that it shall be repaid by the buyer its client).
There are various types of letters of credit:
- commercial letter of credit – this is a direct payment method in which the issuing bank makes the payments to the seller / beneficiary. This can also be known as a regular letter of credit or documentary letter of credit as the sum usually becomes payable on delivery to the bank of the documents required under the contract of sale;
- standby letter of credit – this is a bank’s commitment of payment to a third party in the event that the bank’s client – the buyer – defaults on the payment obligations in the contract with the seller. In other words, the bank will pay if the buyer does not;
- revolving letter of credit – this is where a single letter of credit is relied on by the buyer to cover multiple-shipments of goods over a long period. Instead of arranging a new letter of credit for each separate shipment, the buyer establishes a revolving letter of credit that revolves either in value (which is replenished when exhausted) or for a period of time;
- confirmed letter of credit – this involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, and may be entirely separate to the contracting parties banks. The confirming bank ensures payment under the letter of credit if the buyer and its letter of credit issuing bank default.
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