Types of Letters of Credit: Confirmed, Standby, Transferable

The types of letters of credit explained: confirmed, standby (ISP98), transferable, back-to-back, revolving, red clause, sight and deferred, with examples.

"Letter of credit" covers a family of instruments. Some are payment methods, some are guarantees; some protect the seller against its buyer's bank, others let a trader finance a purchase with its own customer's credit. Picking the right variant, and wording it properly, is often what makes a deal possible at all.

This lesson sorts the family into three questions. How is the credit available: at sight, at a deferred date, by acceptance or by negotiation? Is it confirmed? And does it have a special function: standby, transferable, back-to-back, revolving, red or green clause? For each one you will see who it protects, the UCP 600 or ISP98 rules that apply, and when an exporter should ask for it.

Before you start, make sure you are comfortable with the basic mechanism described in letters of credit explained.

Revocable or irrevocable: a question that no longer exists

Older textbooks still list "revocable" credits. Under UCP 600, which applies to almost all credits issued today, a credit is irrevocable even if it does not say so. A revocable credit is only possible if the credit expressly excludes that rule, which almost never happens and which no exporter should accept: a credit the bank can cancel at any time protects nobody.

How can a credit be available?

UCP 600 article 6 lists four ways a credit can be available. The choice determines when the seller is paid and whether it can obtain funds early.

Under a deferred payment or acceptance credit, the seller can usually obtain cash before maturity by asking the nominated bank to prepay or discount its undertaking; UCP 600 article 12 authorises a nominated bank to do so. See trade finance.

Confirmed and unconfirmed credits

An unconfirmed credit carries the undertaking of the issuing bank only. If that bank fails, or if its country stops transfers abroad, the seller waits or loses.

A confirmed letter of credit carries a second undertaking: the confirming bank, authorised or requested by the issuing bank, adds its own definite undertaking to honour or negotiate a complying presentation (UCP 600 article 8). Once confirmed, the seller presents to its own bank and is paid by it.

• When to ask for confirmation: when the issuing bank is unknown or weak, or the buyer's country has foreign-exchange shortages, political risk or sanctions exposure, or the amount is large.
• What it costs: a commission that reflects the issuing bank and country risk, from very low for first-class banks to several percent a year for difficult markets. Some confirming banks refuse certain countries entirely.
• Silent confirmation: when the issuing bank does not ask for confirmation, the seller can sometimes buy the same protection from its own bank directly. It is outside article 8: the bank's obligations come from a private agreement, often conditional, so read it closely.

Standby letter of credit

A standby letter of credit is a bank undertaking to pay the beneficiary on presentation of a demand, usually with a statement that the applicant has failed to pay or perform. It works like a demand guarantee: if all goes well, it is never drawn.

• Rules: most standbys are subject to ISP98, the International Standby Practices (ICC Publication No. 590), in force since 1 January 1999 and designed specifically for standbys. UCP 600 also applies to standbys to the extent its articles are applicable.
• Examination under ISP98: notice of dishonour must be given within a time that is not unreasonable; three business days after presentation is deemed not unreasonable and more than seven business days is deemed unreasonable.
• Typical uses: securing open account sales (a payment standby), replacing a performance or advance payment guarantee, especially with buyers in the United States where banks have traditionally used standbys instead of guarantees.

A payment standby for an open account relationship typically asks for a demand, a statement that invoices remain unpaid after their due date, and copies of the unpaid invoices and transport documents.

Transferable and back-to-back credits: tools for traders

Traders who buy from one party and sell to another often have no credit line of their own large enough to pay the supplier before the buyer pays them. Two structures let them use the buyer's credit to pay the supplier.

Transferable letter of credit

A transferable credit lets the first beneficiary, usually a trading company, ask the bank to make the credit available in whole or in part to one or more second beneficiaries, usually its suppliers. UCP 600 article 38 sets the rules:

• the credit must expressly state that it is "transferable";
• it can be transferred only once: a second beneficiary cannot transfer it on to a third;
• partial transfers to several second beneficiaries are possible if partial drawings or shipments are allowed;
• the transferred credit must keep the terms of the original, except that the amount, unit price, expiry date, presentation period and latest shipment date may be reduced or curtailed, the insurance cover may be increased, and the first beneficiary's name may replace the applicant's;
• the first beneficiary may substitute its own invoice, and draft, for the second beneficiary's, and draw the difference, which is its margin.

Back-to-back letter of credit

When the master credit is not transferable, or the trader wants to keep its supplier and buyer apart, it can ask its bank to issue a second, separate credit in favour of the supplier, using the master credit as security. The two credits are independent: if the trader's documents under the master credit are discrepant, the trader's bank must still honour the supplier's complying presentation under the second credit. Banks therefore issue back-to-back credits only for creditworthy traders and with terms that mirror the master credit closely. UCP 600 has no specific article for them.

Revolving, red clause and green clause credits

These features adapt a credit to repeat business and to a seller who needs cash before it can ship.

Revolving credit

A revolving credit is reinstated after each drawing, so one credit covers a series of shipments, for example 12 monthly shipments of USD 40,000. It can revolve by time (a new USD 40,000 each month) or by value (reinstated once the previous drawing is paid). It is cumulative if unused amounts carry forward to the next period, non-cumulative if they lapse. It saves the cost and paperwork of opening a new credit for each shipment.

Red clause and green clause credits

These credits allow the seller to draw an advance before shipment, to buy raw materials or the crop:

• Red clause: the advance is paid against a simple receipt and an undertaking to present shipping documents later; if the seller does not ship, the issuing bank, and so the buyer, bears the loss.
• Green clause: the advance is paid against evidence that the goods are stored, such as warehouse receipts, which gives the buyer more security.

They are used in commodity trades where the buyer trusts the seller and wants to finance its harvest or collection.

Comparison: which credit for which need?

Common mistakes

• Accepting an unconfirmed credit from a bank in a high-risk country to save the confirmation fee.
• Treating a credit as transferable because the trader says so, when the word "transferable" is not in the credit.
• Issuing a back-to-back credit with a later shipment date or a longer presentation period than the master credit, leaving the trader unable to comply.
• Agreeing a standby whose expiry falls before the last invoice's due date.
• Drawing up a standby demand that does not match the exact wording the standby requires; as with any credit, a non-complying demand can be refused. See letter of credit discrepancies.