Letter of Credit

A letter of credit is a bank's written promise that it will make a customer's (the holder) payment to a vendor (called the beneficiary) if the customer does not.

​Letters of credit are most common in international transactions, where buyers and sellers may not know each other well or laws and conventions may make certain transactions difficult.

Banks usually require a pledge of securities or cash collateral in order to issue a letter of credit to a holder. Banks also collect a fee for issuing letters of credit , the fee is usually a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs letters of credit used in international transactions.

Letters of credit are usually negotiable instruments, meaning that the issuing bank must pay the beneficiary or any bank nominated by the beneficiary. In some cases, letters of credit are also transferable, meaning that the beneficiary has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).

There are several kinds of Letters of Credit

A Commercial Letter of Credit is one of the most common used for trades. This kind of letter acts as the primary payment mechanism between the customer and the beneficiary, whereby the issuing bank makes the actual payments to the beneficiary every time.

A Standby Letter of Credit, on the other hand, is a secondary payment mechanism, meaning that the bank pays the beneficiary only when the holder cannot.

A Revolving Letter of Credit lets the customer make any number of draws for a certain period as long as they do not exceed a certain limit.

A Confirmed Letter of Credit is a Letter of Credit that has another Bank besides the issuing Bank standing behind it. This second Bank is called the confirming Bank. The confirming Bank ensures payment under the Letter of Credit if the holder and the issuing Bank default on the Letter of Credit.