Letters of credit (信用狀) provide security for businesses on both sides of international trade. However, there are different types of letters of credit, and each has its own unique benefits and drawbacks.

There are four parties involved in a letter of credit: the applicant, the issuing bank, the nominated bank and the beneficiary.

Commercial Letter of Credit

A commercial letter of credit is a financial document from a bank guaranteeing payment to a beneficiary once conditions are met. It’s often required in international business, especially between companies that haven’t done business together before.

These letters of credit help companies work with new businesses without worrying about buyer reliability or nonpayment, allowing for more trusting and reliable trade relationships. They also make it easier to complete deals locally and internationally.

A transferable letter of credit allows the beneficiary to pass along the right to draw from the LC to another party, which can be helpful when there are multiple suppliers involved in a single transaction. For instance, a company that buys parts from multiple suppliers to assemble their products might use a master LC and a back-to-back LC to ensure each supplier gets paid. This can be used to manage inventory and reduce cash flow fluctuations in a business.

Revolving Letter of Credit

Frequently used for international trade, letters of credit are payment mechanisms in which the issuing bank underlying a letter of credit affirms that a purchaser will pay for goods or services on time and in full. The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits oversees letters of credit for international transactions.

Cumulative revolving letters of credit allow for multiple shipments and services to be conducted within a given month while non-cumulative revolving letters of credits allow for one shipment in a given month. Additionally, there is a transferable letter of credit which allows for the beneficiary to transfer their payment right to others. This type of LC is commonly used when middlemen are involved in a transaction.

Finally, there is a time credit or a credit at sight letter of credit which allows for payments to be made on an instant basis when the documents are presented to the bank. This is a common option for small businesses.

Standby Letter of Credit

As the name suggests, a standby letter of credit acts as insurance in the event that a trade fails. It works similarly to a financial or documentary credit, ensuring payment for the seller once certain transaction terms are met. However, unlike other types of LCs that require direct payment from the purchasers to the seller, standby LCs are backed by the bank, lowering the risk for the sellers and making them more likely to be redeemed.

The SBLC is a powerful tool for buyers and sellers when trust between the two parties may be difficult to quantify, especially during international transactions due to distance or different laws in each country. Like a commercial or revolving LC, the LC has the same basic structure that includes the applicant (importer), the beneficiary, the issuing bank, and potentially the advising and confirming banks.

Unconfirmed Letter of Credit

There are a number of advantages to using letters of credit, such as security, risk reduction, funding options and worldwide trade facilitation. However, they do have some drawbacks. These include costs, complexity, the possibility of disparities and reliance on banks.

A letter of credit is a guarantee from a bank that a buyer will pay for products or services provided by a seller. It is particularly useful in international or foreign transactions. This is because it reduces both parties’ risk by ensuring that the buyers will be able to meet their obligations under the precise terms of the letter.

However, the bank will not take this responsibility for free. It will charge a fee for this service, which is usually a percentage of the payment amount. It will also charge fees to the seller, such as courier fees, postage and authentication fees. These charges can add up to a significant amount of money. Therefore, it is important to calculate the total cost of a transaction before entering into one.