What is a letter of credit?

A letter of credit is a means of non-cash settlement of bank customers with counterparties. It expresses the obligation of the credit institution to transfer to the settlement account of the supplier the amount established in the contract after the shipment of the goods or the performance of the service. The current legislation provides for a unified form of this means of payment.

A letter of credit is a guarantee of a successful transaction for both parties. After all, the supplier is sure that the funds necessary for payment are available to the client, and the buyer is protected from losing their own money, as they are on a separate account with the servicing bank until the supplier fulfills its obligations.

So, we learn in more detail what is a letter of credit and what is the essence of the mechanism of its work. When two parties enter into an agreement for the provision of a service, the question of timely payment arises. Especially relevant is the letter of credit for business entities that cooperate for the first time and are not yet sure of the integrity of each other.

So, in the payer's bank a separate account is opened, to which the required amount is transferred. The second party to the contract can receive these cash in cash or require their transfer to an account in his bank only after the submission of a document certifying the fact of the end of the transaction.

A bank letter of credit can be of several types.

The revocable type assumes that there is the possibility of canceling or making corrections to the issuing bank's client without prior notice to the other party to the agreement. In some cases, the credit institution decides to cancel it without the client's acceptance. If the conditions remain the same, the supplier's bank presents documents confirming the fulfillment of obligations to the buyer's bank, on the basis of which the latter must immediately transfer the money.

Of course, a revocable letter of credit is not guaranteed to the fullest, so in practice it is used quite rarely. As a rule, it is chosen by organizations that have cooperated for a long time and the degree of trust between them is quite high.

Irrevocable letter of credit is a commitment of a bank that does not tolerate any changes or adjustments. That is, if the supplier has submitted the necessary documents confirming the fact of the shipment of the goods, then the money must be transferred unconditionally. In practice, this type of calculation is used much more often, since it gives the beneficiary confidence in clear compliance with the terms of the contract.

There is an unspoken rule: when the letter of credit does not specify a specific type (revocable or not), it is automatically considered to be irrevocable.

You can also highlight an unconfirmed and confirmed form. The first can not be canceled or make any adjustments without the acceptance of the second party. A confirmed irrevocable letter of credit is considered to be the most reliable, since the beneficiary bank notifies about the obligation to provide documents. In this case, banks work together, which guarantees the high-quality execution of requirements.

Revolving letter of credit is a renewable obligation of the bank. As a rule, it is used between contractors planning further cooperation, for example, when delivering certain products in batches. In this case, bidders do not have to ask the bank to open a separate account each time. It simply reserves a large amount, from which, after each delivery, funds are transferred to the account of the beneficiary. This process is repeated until the amount is exhausted. Then the next replenishment is carried out - and the work continues in the previous mode.

In Europe, letters of credit with a green or red clause have been distributed. The first type is otherwise called a letter of credit with a deferred payment, that is, the money is transferred after a certain period of time after the delivery of shipping documents to the issuing bank. And the form "with a red clause" assumes delivery of advance payment to the supplier before submission of the documentation.