Letter of credit. Types of letters of credit and methods of their execution

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

A letter of credit is a financial transaction in which an order is issued to the payer's bank in the direction of the beneficiary's bank. Banking manipulation is carried out at the initiative of clients, on their behalf in accordance with the partnership agreement. The order consists in making payments by an individual or legal entity within the framework of the agreed conditions under the order.

Examples of banking transactions

Having studied the concept and types of letters of credit, we will focus on the fact that this format of mutual settlements through a bank has both positive aspects and its drawbacks. A letter of credit can be called a conditional monetary obligation, which is accepted by the bank at the direction of the applicant, according to which the financial institution assumes the obligation to pay the beneficiary in the amount specified in the documents. This determines a high level of security and acts as a guarantee that none of the parties will be deceived. It is possible to describe the situation more simply. For example, one firm wants to purchase a certain product from another, but due to risk does not want to pay for it right away. In this situationthe buyer asks the bank to pay for the goods for him, providing him with a receipt that the payment will occur later, upon receipt of the goods. The bank transfers a certain amount of funds to the seller, and then, on the basis of a receipt, collects funds from the buyer. Settlements with the bank and between the parties in this format are known as settlements by letters of credit. Types of letters of credit determine the individual subtleties of partnership between 4 parties.

Letter of credit as a form of risk minimization

When forming partnerships between an entrepreneur and an organization, as well as between individuals and individual entrepreneurs, there is a high risk of losing money or goods when concluding an agreement or in mutual settlements. The types of letters of credit presented in the banking sector make it possible to avoid significant losses when conducting transactions for large amounts. Risks are minimized due to the fact that any financial process within the framework of a letter of credit is implemented under strict control simultaneously by two banks. Failure to comply with the terms of the contract with either party is completely excluded. The supplier of products, in fact, as well as its buyer, simply cannot fail to fulfill their obligations under the partnership.

Types of letters of credit

When using letters of credit for mutual settlements, it is extremely important to choose the appropriate type of operation. The opening of the latter is carried out by the bank solely at the direction of the payer, therefore, the choice regarding the format of the operation remains with the payer. Information regarding the suspected subtype of bankingtransactions are included in the contract. In accordance with the standards of the Central Bank of the Russian Federation, it is customary to distinguish the following types of letters of credit:

• Covered, or deposited.
• Uncovered, or guaranteed.
• Revocable.
• Irrevocable.
• Confirmed. It can be either revocable or irrevocable.

Covered and uncovered banking transactions

Deposited and guaranteed transactions are the most common settlements by letters of credit. Types of letters of credit determine the specification of the operations themselves.

• Covered operation. In this situation, when opening a letter of credit, the issuing bank transfers funds from the payer's account for the entire amount of the letter of credit. This is called coverage. Funds are transferred to the disposal of the executor's bank for the entire term of the contract.
• Uncovered transaction. A guaranteed banking operation provides for the transfer of funds by the issuing bank when opening a letter of credit. The executing bank is simply given the right to write off funds from its account within the value of the letter of credit. The procedure for debiting funds from a correspondent account held with the issuing bank is determined by special agreements between financial institutions.

Variations of a confirmed bank transaction

A confirmed letter of credit, the types of which may differ depending on the specification of transactions (revocable and irrevocable), is a letter of credit, withfulfillment of which the executing financial institution assumes obligations to make the payment, regardless of the fact of transferring money from the bank where the confirming letter of credit was issued. The procedure for agreeing on the nuances of the operation is determined by interbank agreements. The answer to the question of what combination of types of letter of credit is impossible lies precisely in the definition presented above. Other tandems are simply unacceptable.

Revocable and irrevocable transactions

Both revocable and irrevocable letters of credit are considered to be no less popular in mutual settlements. Types of letters of credit in this category also have their own specifics.

• A revocable banking operation can be upgraded or completely canceled by the issuing bank. The basis for refusal may be a written order of the payer. Coordination with the recipient of funds in this situation is not required. After the withdrawal of the letter of credit, the issuing bank does not bear any responsibility to the payer.
• A fail-safe transaction can only be revoked if the recipient agrees to change the terms of the partnership and submits it to the executing bank. Partial change of conditions for this category of mutual settlements is not provided.

The recipient of funds for a banking transaction has the right to refuse payment, but until the expiration of its validity period and provided that this nuance is specified in the contract. Allowed by prior arrangement and acceptance of a third party, whichauthorized by payer rights.

Varieties of the main formats of banking operations

There are not only the main types of letters of credit, but also their varieties. The following bank transaction modifications can be mentioned:

• With a red clause. This is an agreement in accordance with which the issuing bank grants the right to the executing bank to make payment in the form of an advance to the supplier of goods. The amount of the advance is determined in advance and is provided before the service is rendered or the goods are shipped. It is these types of letters of credit that are most in demand in international settlements, as they increase the level of trust between the parties.
• Revolving operation. It is a letter of credit, which is opened partially for payments within the contract amount. It is automatically updated as you pay for each of the consignments of goods or for a certain amount of services. For a cyclical reduction in the monetary volume of the contract with systematic deliveries, this letter of credit is ideal. Types of letters of credit in this category are popular.

Mutual settlements

When concluding contracts, the contracts must indicate the form of mutual settlements, as well as the features of the delivery of goods or the scheme for the provision of services. The planned types of letters of credit and their characteristics are necessarily prescribed in the papers. Papers should contain the following information to avoid problems:

• Name of the issuing bank.
• Name of the financial institution that willservice to the recipient of funds.
• Identification data of the recipient of funds.
• Bank transaction size.
• Types of documentary credit to be used.
• Format of informing the recipient about the opening of a bank transaction.
• Format of informing the payer about the account number, which is intended for depositing money. The account is opened by an executing financial institution.
• The validity period of the letter of credit itself, the terms for the provision of documents and the rules for their execution.
• Deal payment specification.

Important points

In order for the partnership to be successful, the payer must independently or with the help of a specialist study this format of banking operations, focusing on who uses which types. Letters of credit differ depending on the format of mutual settlements. For a particular case, you need to choose the optimal partnership format. It is worth saying that in case of violation of the settlement format, all responsibility is assigned to financial institutions in accordance with the law. This determines the fact that representatives of financial institutions are especially attentive to the verification of documentation that confirms the delivery of goods, the performance of a certain amount of work or the provision of a service.

Advantages and disadvantages

This type of cashless payment has both pluses and minuses. The positive aspects of the partnership include the presence of a 100% guarantee of paymentseller of goods or service provider. Control over the implementation of mutual settlements under the transaction is carried out by the financial institutions themselves, which eliminates the risk of fraud and the proper fulfillment of their obligations by each of the parties. When carrying out a banking operation, due to the deferred payment, the buyer does not withdraw part of the capital from the economic turnover. Payment for goods or services is carried out as if in installments. At the time of signing the contract, the buyer may not have funds in his hands. This moment also acts as a disadvantage, but already for the seller of goods and the representative of services. They receive money with a delay. It is worth mentioning that the partnership scheme for a letter of credit is very complicated, it will not work out right away. However, world practice shows that businessmen who once took advantage of the offer never use other payment formats. The advantage in terms of high security indicators completely covers the complex workflow and relatively high commissions of banks.