Sorts of Letter of Credit and Risk in Transactions

Letter of Credit are a financial tool that can be very useful in some situations. It is most often used in international trade, where they are governed by the Uniform Customs and Practice for Documentary Credits (UCP) rules of the International Chamber of Commerce.

Types and Features of Letter of Credit

Import/export Letter of Credit are used in international trade. In most cases the importer is the buyer and the exporter is the beneficiary. The Revocable letter of credit can be changed at any time by either the buyer or the issuing bank with no notification to the beneficiary. The Irrevocable letter of credit only allows change or cancellation of the Letter of Credit by the issuing bank after application by the buyer and approval by the beneficiary. A Confirmed Letter of Credit is one where a second bank agrees to pay the letter of credit at the request of the issuing bank. An Unconfirmed Letter of Credit is guaranteed only by the issuing bank. 

The Transferable Letter of Credit are commonly used when the beneficiary is simply an intermediary for the real suppliers of the goods and services or is one of a group of suppliers. It allows the named beneficiary to present its own documentation but transfer all or part of the payment to the actual suppliers. As you might guess, an Un-transferable Letter of Credit does not allow transfer of payments to third parties. A Red Clause Letter of Credit allows the beneficiary to receive partial payment before shipping the products or performing the services. Originally these terms were written in red ink, hence the name. In practical use, issuing banks will rarely offer these terms unless the beneficiary is very creditworthy or an advising bank agrees to refund the money if the shipment is not made.

Finally, a Back to Back letter of credit is used in a trade involving an intermediary, such as a trading house. It is actually made up of two Letter of Credit, one issued by the buyer's bank to the intermediary and the other issued by the intermediary's bank to the seller.

Risks in Letter of Credit Transactions

Letter of Credit transactions are not without risks. The risks inherent in these types of transactions include:

• Fraud risk, in which the payment is obtained through the use of falsified or forged documents for worthless or nonexistent merchandise.
• Regulatory risk, in which government action may prevent completion of the transaction.
• Legal risk, in which legal action prevents completion of the transaction.
• Force majeure risk, in which completion of the transaction is prevented by an external force such as war or natural disasters.
• Failure of the issuing or collecting bank.
• Insolvency of the buyer or beneficiary

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