A letter of credit is a means of cashless settlement of bank customers with counterparties. It expresses the obligation of the credit institution to transfer to the supplier’s bank account the amount specified in the contract after the shipment of the goods or the performance of the service. 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 confident that the client has the funds necessary for payment, and the buyer is protected from losing their own money, since they are on a separate account in the bank serving it until the supplier fulfills its obligations.
So, we learn in more detail what a letter of credit is and what is the essence of the mechanism of its work. When two parties enter into an agreement to provide a service, the question arises of timely payment. The letter of credit form of settlement is especially relevant for business entities that cooperate for the first time and are not yet sure of each other's integrity.
So, a separate account is opened in the payer's bank, to which the required amount is transferred. The second party to the contract can receive this cash in cash or require their transfer to the account in his bank only after providing a document certifying the completion of the transaction.
A bank letter of credit can be of several types.
The revocation type implies the possibility of canceling or making adjustments by the client of the issuing bank without prior notification of the other party to the agreement. In some cases, the credit institution decides to cancel it without the customer’s acceptance. If the conditions remain the same, the supplier’s bank presents the 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 fully guaranteed, so it is rarely used in practice. As a rule, it is chosen by organizations that have been cooperating for a long time and the degree of trust between them is quite high.
An irrevocable letter of credit is a bank commitment that does not tolerate any changes or adjustments. That is, if the supplier has submitted the necessary documents confirming the fact of shipment of the goods, then the money must be transferred unconditionally. In practice, this type of settlement is used much more often, as it gives the beneficiary confidence in the strict fulfillment of the terms of the contract.
There is an unwritten rule: when a specific type is not indicated on the letter of credit (revocable or not), it is automatically considered irrevocable.
You can also highlight the unconfirmed and confirmed form. The first one cannot be canceled or any corrections made without the acceptance of the second side. A confirmed irrevocable letter of credit is considered the most reliable, since the beneficiary bank notifies you of the undertaking to provide documents. In this case, banks work together, which guarantees high-quality fulfillment of requirements.
A revolving letter of credit is a renewable obligation of a bank. As a rule, it is used between counterparties planning further cooperation, for example, in the delivery of certain products in batches. In this case, the parties to the transaction 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 beneficiary's account. This process is repeated until the amount has been exhausted. Then the next replenishment is carried out - and the work continues in the previous mode.
Letters of credit with a green or red clause have spread in Europe. The first type is otherwise called a letter of credit with a deferred payment, that is, money is transferred after a certain period of time after the presentation of shipping documents to the issuing bank. And the “with a red reservation” form involves the issuance of an advance to the supplier before the submission of the documentation.