This post provides a detailed explanation of the different types of letters of credit . We'll teach you about each of their characteristics and more.
Types of letter of credit
When we seek to identify the types of letters of credit, we can find several payment instruments that are subject to different national or international regulations; it all depends on the instructions that both clients and banks or beneficiaries establish as banking documents.
Summarizing the information that we have established or better encompassing the definition of what letters of credit mean, we find that they are the promises that are established between any financial or credit institution with the relationships of people or individuals who want to establish a fixed-term issue condition banking.
That is why we must know the classification of the credit contracts that we can establish with financial institutions, since these classifications allow us to understand and understand the benefits of each of them. That is why below we are going to classify the types of letter of credit that we can get.
To better understand these banking definitions, their uses, benefits and characteristics, we leave you the following audiovisual material for your enjoyment
revocable credit
When we refer to the types of revocable letter of credit, we are talking about the different banking platforms that allow us to obtain modifications or cancellations that we can make at any time during the life of the types of letter of credit without needing the approval of the beneficiary. These types of letter of credit are mostly not acceptable due to the great risk they represent.
irrevocable credit
These types of letter of credit are very characteristic since they need to be made up of three essential parts: the applicant, the financial institution and the beneficiary. This financial instrument is the most used since the payment of these types of letter of credit is legally linked to property or asset documents that ensure full payment. It is known as irrevocable credit since to be transferred it needs the three signatures of the components that make up this financial transaction.
Within this classification it is common to find other types of letter of credit but they are used much less frequently by financial institutions, these are:
You confirm
This is one of the most unusual types of letter of credit that we can get in the market, thanks to the fact that we, as clients or suppliers, trust a financial institution for the activities that we carry out abroad. This means that we will not have control of commercial activities or payment but that we will trust this bank one hundred percent.
The financial institution will only notify us of the export and the payment that it executes, we will only contract its services and we will not have any more voice within the commercial operation, which is a great movement within the market since we cannot comment on the quality of the products.
backed
These financial instruments are defined within the market by including two commercial operations, this means that one of these types of letter of credit is made up of two. This instrument allows sellers or intermediaries who do not have the financial lung to qualify for a bank loan to obtain it through the second letter signed by the supplier.
We explain to you, if we as buyers do not have the financial support we need to request the bank credit, but we already require it, we can execute a letter of credit in the name of the supplier so that the financial institution executes the payment in its name and we can execute the commercial activity that we want.
It is important to note that these types of letter of credit are very rare in the market since for financial institutions they are two different banking activities that mean a lot of risk and little productivity at a financial level. So much so that banks will request extensive documents to verify that the first letter of credit does not have the financial strength to be charged.
standby
This is one of the easiest types of credit to highlight within the different financial operations since it focuses on being more of a bank guarantee than a payment mechanism.
Standby letter of credit types work by withholding from the seller the portion of the condition that has been established as a form of payment to ensure the cancellation of the debt. IF due to outside or third party reasons the payment cannot be executed at that time, the letters of credit are drawn, which are of much more important legal weight and with completely different powers to demand the payment that is due. These types of letter of credit generally expire twelve months after application and execution.
Advance on account against letter of credit
This financial instrument will work and will be executed in the same way as the types of supported irrevocable letter of credit, with the difference that the bank or financial institution, instead of issuing another letter of credit, will make cash in the supplier's accounts. that we have established in the statutes or specifications of the elements that we are working on.
transferable credit
When we talk about one of the types of letter of credit, we get the transferable credit that focuses each of its activities on the option of being able to transfer its benefits to a third party not stipulated at the beginning of the banking operation. These types of actions are used when the main beneficiary works with exports, so the final beneficiary is not him, but rather a house that hires his services.
We must understand that when we decide to use these types of letter of credit, we as exporters are going to completely avoid using the awarded credit or our own funds to make the purchase that our client wants. At that moment, the transferable letter of credit comes to life, since with the issuance in writing to the bank that liquidates the funds, we will give the data of our client so that their funds are liquidated and the commercial operation can be executed.
These financial instruments have very specific risks since, as they seek to import into the country, the validity of the products is not certain when buying, unless there is a history with those suppliers. However, in these types of letter of credit it is normal to see the request for an independent inspection certificate in order to guarantee the quality and the raw material with which the products that are being purchased are the one required by our clients.
Another of the negative elements that are considered within the types of transferable letter of credit is the almost perfect coordination of the three elements that make up this financial instrument to execute payments to the fourth person involved, since if there is inaccurate information about this can be achieved with the veto of the bank.
Back to Back
When we talk about the types of letter of credit, we realize that they are the financial instruments that define the benefit of the credit with the final supplier. These credits are classified as non-transferable since we cannot request a supporting document from our financial institution, regardless of whether this is the first one we receive from the bank.
It should be noted that when establishing these types of letter of credit, it is made up of two financial transactions, one is the responsibility of the export received and the other focuses on supporting the credits that are established.
Benefits of the types of letter of credit
When we use these financial instruments we manage to establish benefits for our businesses or employment contracts. Among which we can mention the different consultancies that focus on the specialization of being able to verify the terms and those conditions that are established within the credit established by financial institutions.
In the same way, the different types of letter of credit allow us to obtain a great availability on the part of the financial institutions to obtain the different proofs of payment of both the commissions and the expenses that we have established.
Another benefit of using different types of letter of credit is that it allows us to review the different documents that fully ensure adherence to the different contracts with the financial institutions that are established in the documents.
It should be noted that managing these financial instruments within our portfolio is a reason of importance and security for different investors who want to do business with us. This arises thanks to the fact that we can give the security that we are a reliable, thriving and established organization within the market. So much so that we can conduct extremely complicated business from a financial point of view.
When we find these types of letters of credit in investment portfolios, we can establish a safe return and we can even talk about paying interest on the capital that we can invest in this financial operation.
If you want to know how to set up a portfolio or how to read it to understand how to manage money wisely, we've included the following link: Investment Portfolio. This will help you complete your analysis of the best types of letters of credit you can request for your business, company, or organization.
On the other hand, we can achieve speed in the payment of the documents established by the contracts of the different types of letter of credit and it provides us with information that is timely and completely truthful by the different financial institutions.
And lastly, the benefits that can be registered within the receipts, the different commissions and bank expenses to be imputed in the prices of the products that we commercialize.
Parties involved in the letter of credit
As we have determined in different points of this article, the different types of letter of credit establish agreements or bank loans that unite different parties or elements in a commercial and financial way, which are:
payer
When we speak of the originator within the specifications of the different components that make up or establish the birth of the different types of letter of credit, we are referring to those buyers or importers who request the opening of this financial instrument, in order to bring merchandise that is of quality and high consumption.
In the same way, it is extremely important to understand that the different letters of credit will recognize as the payer the legal or natural persons who request the opening of the letter in order to turn the presentation of these and achieve complete evidence of the shipment of the merchandise. that we want to trade.
One of the most outstanding characteristics about the payers is the way in which they manage to participate through two completely different links with extremely different characteristics, which are characterized by:
- The purchase and sale link that has been established directly between the ordering party and the beneficiary regardless of the different types of letter of credit that the beneficiary may request from the banking entities.
- Finally, we can obtain the link between the payer and the bank that made or settled the different types of letter of credit that we can request. We must understand that the bank that grants the conviction of the execution of the letter of credit is the one that will determine, through the account of the ordering party, the conditions dictated by the types of letter of credit.
Beneficiary
This is another of the parties that are needed for the birth of the letter of credit, it is the beneficiary who is the one for whom the different types of letter of credit will be issued. The beneficiary can demand payment directly when it has been possible to comply with each of the different terms or conditions that have been established from the beginning.
Although it is important to note that to demand the payment of the letters of credit we must obtain or record different legal documents for the execution of the liquidity established in these financial documents.
Banks
In relation to the banks that intervene in the execution and liquidation of the different types of letter of credit, we find different figures of the banking institutions, which are:
issuing bank
When we seek to establish that it is the issuing bank within the financial transactions that we are defining within this scheme, we have that it is the financial institution that is in charge of issuing the types of letter of credit. On the other hand, the issuing bank is the one that focuses the responsibility on the payer in order to be able to notify the seller or beneficiary of the payment or execution of the liquidity of this financial instrument.
confirming bank
As we have defined throughout the article, banks or financial institutions are the main reason why these benefits can be granted, that is why when we speak of the confirming bank we refer to the institutions that will assume in front of the beneficiaries or sellers the different obligations that must be canceled or paid.
These payments must be made regardless of what has been received at any time from the issuing bank. We must understand that regardless of the types of letter of credit, we are establishing a payment commitment that is created before the beneficiary or seller and the financial institution, whether it is the issuing bank or the confirming bank.
Reporting Correspondent Bank
This figure of financial or banking institution arises when the issuing bank of the types of letter of credit lacks or does not have any branch in the area where the beneficiary or seller resides that has been established from the moment of the execution of these financial instruments.
This financial institution can exercise the functions of the advising bank without the need to acquire any of the obligations that have been established before the seller or the beneficiary in order to be able to regulate in a practical way the commercial activity of this financial instrument.
paying bank
The paying bank or the financial institution in charge of the reimbursement is the one in charge of making the different payments owed to the seller or the beneficiary. This will be agreed at the beginning of the financial activity created in the letter of credit to avoid inconveniences at the time of executing the liquidation of the currency. It is important to note that the paying or reimbursing bank is not obliged to fulfill or execute the payments as long as it has not received the liquidity funds from the aforementioned banks, issuer or confirmer.
trading bank
This figure arises when the bank or financial institution decides to negotiate or advance the payments that are established in the payment clauses of the different types of letter of credit so that the seller or the beneficiary achieves some payment that can be made to your debt against the exposure of the different documents that are named or detailed at the time of establishing the letter of credit.