What Is a Commercial Letter of Credit?
“What is a commercial letter of credit” is a common question for business owners.3 min read updated on February 01, 2023
“What is a commercial letter of credit” is a common question for business owners. A commercial letter of credit is a contractual agreement between the banks issuing the credit that authorizes another bank to make payments to the beneficiary on behalf of the customer.
Commercial Letter of Credit
A commercial letter of credit is written on behalf of the customer and allows a different bank than the one issuing credit to make a payment to the beneficiary. In the letter, the issuing bank promises to allow draws made on the credit. The idea behind a letter of credit is similar to escrow. A bank acts as a neutral party and only releases funds after the parties meet certain requirements. In most situations, the beneficiary provides the products or services. Under a letter of credit, the issuing bank takes over from the bank's customer as the payee.
Commercial letters of credit have a longstanding history in international trade. For international matters, the letters are overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The provisions from this group are required for all parties. In the U.S., domestic collections are overseen by the Uniform Commercial Code.
Protection Offered by a Commercial Letter of Credit
A commercial letter of credit offers protection to both parties. The seller is protected because if they don't receive payment from the buyer, the bank that issued the letter of credit is then responsible for paying the seller. That means that the seller knows they will always receive some kind of payment. This is especially helpful for international deals where the buyer and seller are in different countries.
Buyers are protected because if they pay for a product or service that they don't receive, the buyer may be able to get some money back through a standby letter of credit. The payment is similar to a refund and allows the buyer to then find another company to buy the product or service from.
Types of Letters of Credit
There are multiple kinds of letters of credit, each of which is best used in certain situations.
- A commercial letter of credit offers direct payment from the bank to the beneficiaries receiving payments.
- A revolving letter of credit lets the customer pull money from the bank in an unlimited number of transactions within a specific time frame.
- A traveler's letter of credit promises that the bank will accept drafts through accepted foreign banks.
- A confirmed letter of credit includes a second bank that guarantees the letter of credit. This bank is usually the seller's bank and is known as the confirming bank. In the case that both the issuing bank and the customer can't make payments, the confirming bank will step in to make payments. This type of arrangement is usually requested by the issuing bank in international deals.
- A standby letter of credit works as a secondary payment tool. A bank issues a standby letter of credit to show that a customer is able to make payments under the terms of the agreement. Both parties expect to never have to draw on this type of letter of credit; the letter is simply there to provide additional support for the customer's financial standing. However, if the customer doesn't meet their obligation, the beneficiary is able to provide evidence and draw on the credit.
Standby letters of credit come with expiration dates and are used to back up monetary obligations, ensure that an advanced payment is refunded, and to assure that a sales contract is completed. These types of letters are typically used to strengthen the creditworthiness of a customer. In most cases, a standby letter of credit is never actually used, especially if the customer makes payments according to the terms set by the seller.
However, if the seller wants to be paid directly and the customer can't pay, the seller can provide evidence and draw on the credit. In domestic situations, the Uniform Commercial Code states that banks have three business days to accept the evidence that payment hasn't been made to then honor the seller's draw on the credit.
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