Letters of credit (LCs) serve as critical risk management tools in international trade, providing payment guarantees between unfamiliar parties across borders. These financial instruments, issued by banks, come in four primary variations tailored to different transaction requirements. From import/export deals to construction projects, LCs bridge trust gaps by substituting bank credit for buyer creditworthiness. This guide explains each LC type's structure, typical use cases, and documentation requirements, offering businesses a framework for selecting the optimal instrument for their cross-border transactions.
Commercial and Standby LCs
Commercial letters of credit are payment guarantees for goods shipments—the most common LC type. Importers' banks promise to pay exporters upon presenting compliant shipping documents (bills of lading, invoices, certificates). These are either revocable (rare) or irrevocable (can't change without all parties' consent). Standby letters of credit function like insurance policies—only paid if the applicant defaults. These backup guarantees support performance obligations like construction contracts or loan repayments. They're governed by ISP98 rules rather than UCP600. While commercial LCs facilitate trade, standby LCs mitigate non-performance risk—the former expects payment, the latter hopes to avoid it. Fees typically range 0.5-2% of LC value annually, depending on applicant creditworthiness.
Revolving and Confirmed LCs
Revolving letters of credit automatically renew for multiple shipments under one master agreement, ideal for ongoing supplier relationships. They may be cumulative (unused amounts carry forward) or non-cumulative (amounts expire each period). Confirmed letters of credit add a second bank's guarantee (usually in exporter's country) to mitigate political or foreign bank risk. The confirming bank commits to pay even if issuing bank defaults—critical for dealing with unstable jurisdictions. Confirmation fees add 0.5-1.5% to costs but provide substantial risk reduction. Specialized variations include red clause LCs (advance payments to producers) and transferable LCs (allowing middlemen to assign portions to suppliers). Choosing the right LC type depends on transaction risk, relationship history, and goods characteristics like production timelines.
Key Takeaways
Letters of credit remain indispensable tools for managing payment risk in global commerce, particularly for new trading relationships or volatile markets. By matching LC types to specific transaction risks—commercial LCs for routine shipments, standby LCs for performance guarantees, revolving LCs for ongoing supply chains, and confirmed LCs for high-risk jurisdictions—businesses can expand internationally with greater confidence. Always consult trade finance specialists when structuring these instruments, as small documentation errors can invalidate payment obligations. When used precisely, LCs provide the security needed to explore profitable opportunities worldwide while protecting against non-payment and performance risks.