Letter of credit and types: sight, usance, confirmed, transferable and more

Letter of credit and types at a glance

All letters of credit (LCs) share one core: a bank promises to pay a seller if the seller presents documents that comply with the credit (International Chamber of Commerce). The types differ in how the promise is built. ICC, the body that writes the rules most LCs follow, lists irrevocable, confirmed, revolving, red and green clause, transferable, back-to-back and standby credits (International Chamber of Commerce). Sight and usance describe when payment happens.

Sight and usance

A sight LC is "available by sight payment". The bank pays as soon as it finds the documents in order. A usance LC is available by deferred payment, or by acceptance of a draft. The bank promises to pay at maturity, or it accepts a bill of exchange drawn by the seller and pays it on the due date (International Chamber of Commerce).

Cost differs too. On Bank of Baroda's published card for an inland LC where the borrower is not a large corporate, a sight LC carried 0.70% for the validity period. A usance LC carried 0.75% to 2.40% a year, depending on rating (Bank of Baroda). The card shows an effective date of 10-Dec-2022 and is an example, not an offer.

Irrevocable and revocable

An irrevocable credit can be amended or cancelled only with the agreement of the seller and, if there is one, the confirming bank. UCP 600 makes every credit irrevocable by default, even if it does not say so (International Chamber of Commerce). If someone asks about a "revocable LC", the short answer under today's rules is that the idea no longer exists in the ICC rules for documentary credits.

Confirmed LC

Confirmation is "a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation" (International Chamber of Commerce). The seller usually asks for it in the sale contract. It matters when the issuing bank is little known, or when the buyer's country carries payment or political risk. The seller then has two banks behind the promise.

Confirmation has a price. Bank of Baroda's card lists 0.20% a month for the period of validity and usance (Bank of Baroda).

Revolving LC

Normally a used-up LC needs an amendment before it can be topped up. A revolving credit restores its value instead. It can revolve over time, for example each month, and be cumulative or non-cumulative, or revolve by value as each draw is paid (International Chamber of Commerce). It suits regular supply to one buyer, because the buyer does not open a fresh LC each time.

Red clause and green clause

A red clause lets the seller draw on the credit before shipment and before presenting documents. ICC notes that the clause was historically written in red ink. A green clause is similar but also requires the goods to be stored in the bank's name as security (International Chamber of Commerce). Both help a seller who needs cash to buy or make the goods. They carry more risk for the buyer and the bank, so they are less common.

Transferable LC

A transferable credit lets the seller, called the first beneficiary, transfer it fully or in part to one or more other parties, the second beneficiaries. The credit must clearly state that it is transferable (International Chamber of Commerce). Under UCP 600 this is covered by Article 38. A trader who buys from a supplier may use it. The bank charges for each transfer. Bank of Baroda's card shows ₹500 a transfer (Bank of Baroda).

Back-to-back LC

A back-to-back arrangement uses two separate credits. The master credit is in favour of the middleman. The second, back-to-back credit, is in favour of the source supplier. Its amount, unit price, expiry date and shipment date usually differ from the master's, so the middleman keeps a margin (International Chamber of Commerce). It is not the same as a transferable LC, because the second credit is a new LC issued on the strength of the first.

Standby LC (SBLC)

A standby letter of credit pays only if the applicant fails to perform. ICC calls it "a secondary obligation covering default only" (International Chamber of Commerce). In effect it works like a bank guarantee. A different set of ICC rules often applies to standbys and to demand guarantees (International Chamber of Commerce). Bank of Baroda's card showed standby LCs against trade credits at 1% a year for amounts below ₹5,00,00,000, and 0.40% a year on the entire amount at ₹5,00,00,000 and above (Bank of Baroda). To see how a standby differs from a guarantee in practice, read letter of credit vs bank guarantee.

The main types on one published card

To show how pricing differs by type, here are the items on Bank of Baroda's card (effective 10-Dec-2022). They are examples, set by the bank, and not an offer.

How the type shows up in the LC itself

You rarely see the word "type" on an LC. The wording tells you. Look for how the credit is available: by sight payment, by deferred payment, or by acceptance of a draft (International Chamber of Commerce). Look for the words "confirm", "transferable" or "standby". Look for any clause that lets you draw before shipment. If the wording is unclear, ask the issuing bank to explain it before you ship.

Which type should a small business ask for?

• A seller who doubts the buyer's bank asks for confirmation, and asks for sight if cash is tight.
• A buyer who needs time to resell asks for usance, which costs more in commission but gives credit time.
• A repeat trader may use a revolving LC to avoid opening a new LC for each order.
• A trader in the middle may use a transferable or back-to-back LC.
• A business that must show it will perform a contract usually needs a standby or a bank guarantee instead.

The bank decides which of these it will issue, and at what margin. It assesses you as it would for a loan, which is why a loan readiness check is a sensible first step. Capnix does not issue LCs. See the trade finance hub for the other instruments.