Letters of credit (LCs) are vital financial instruments used in international trade to facilitate secure and efficient transactions between buyers and sellers across borders. LCs provide assurance of payment to sellers upon compliance with specified terms and conditions, thereby mitigating payment risk and enhancing trust between trading parties. In this comprehensive guide, we’ll delve into the three most-used types of letters of credit, their features, applications, and implications for global trade and commerce.
1. Sight Letter of Credit:
Definition: A sight letter of credit, also known as a documentary credit, is a type of LC where payment is made to the beneficiary (seller) immediately upon presentation of compliant shipping documents. The issuing bank pays the beneficiary upon verifying that the documents meet the terms and conditions stipulated in the LC.
Features:
Payment is made promptly upon presentation of documents, typically within a few days of receipt.
The beneficiary does not need to wait for the buyer to accept or approve the goods before receiving payment.
Sight LCs provide certainty and assurance of payment to sellers, enhancing their confidence in completing transactions.
Applications:
Sight LCs are commonly used in international trade transactions where sellers require immediate payment upon shipment of goods.
They are suitable for transactions involving perishable goods, time-sensitive deliveries, or situations where sellers require upfront payment to cover production or procurement costs.
2. Usance Letter of Credit:
Definition: A usance letter of credit, also known as a time or deferred payment LC, is a type of LC where payment is made to the beneficiary at a future date specified in the LC, after a predetermined credit period (e.g., 30, 60, or 90 days) from the date of presentation of compliant documents.
Features:
Payment is deferred until the maturity date specified in the LC, allowing buyers additional time to inspect goods and generate revenue before making payment.
Usance LCs provide flexibility for buyers to negotiate longer payment terms with sellers, improving cash flow management and working capital efficiency.
The seller retains control over the goods until payment is received, reducing the risk of non-payment or disputes.
Applications:
Usance LCs are widely used in trade transactions involving bulk commodities, capital equipment, or large-volume shipments where buyers require extended payment terms.
They are suitable for buyers who need time to inspect goods, secure financing, or generate revenue before making payment to sellers.
3. Revocable Letter of Credit:
Definition: A revocable letter of credit is a type of LC that can be amended or canceled by the issuing bank without prior notice to the beneficiary or the applicant. The terms and conditions of a revocable LC can be changed or revoked at any time before payment is made to the beneficiary.
Features:
Revocable LCs provide flexibility for the issuing bank to modify or cancel the LC based on changes in circumstances or instructions from the buyer.
They offer less security and certainty to beneficiaries compared to irrevocable LCs, as payment may be revoked or delayed at the discretion of the issuing bank.
Revocable LCs are rarely used in international trade due to their inherent risks and lack of protection for sellers.
Applications:
Revocable LCs are seldom used in modern trade finance due to their limited security and reliability for sellers.
They may be used in certain domestic transactions or situations where buyers and sellers have a high level of trust and familiarity with each other.
Comparison and Implications:
Risk and Security: Sight LCs offer immediate payment to sellers, while usance LCs provide deferred payment terms. Revocable LCs offer less security to beneficiaries compared to irrevocable LCs.
Flexibility: Usance LCs provide flexibility in payment terms, allowing buyers to negotiate longer credit periods. Revocable LCs offer flexibility for the issuing bank to amend or cancel the LC.
Applicability: The choice of LC type depends on the specific requirements, preferences, and risk tolerances of buyers and sellers in international trade transactions.
Conclusion
Letters of credit are essential tools in international trade, providing assurance of payment and mitigating risks for buyers and sellers. The three most-used types of LCs—sight, usance, and revocable—offer different features, applications, and implications for trade transactions. Understanding the characteristics and suitability of each type of LC is crucial for businesses, traders, and financial institutions to effectively manage risks and facilitate seamless trade operations across borders.
