What is a letter of credit in simple words? This question can be found quite often on the World Wide Web. Many people believe that this word is used to denote some complex term that is incomprehensible to the average person, but in reality everything is simpler than it seems. In our article today we will explain in detail what a letter of credit is in a bank. Interested? Then start exploring quickly!

We won’t beat around the bush, but will immediately give an answer to your question. To put it in the simplest possible terms, a letter of credit is one of the best and most reliable ways to protect your organization from the risks associated with prepayment for financial transactions. A letter of credit provides an opportunity to insure yourself when collaborating with new partners. In this situation, the bank is an intermediary that temporarily stores funds in a special account. He also acts as a kind of guarantor who takes responsibility for the payment of finances. This creates favorable conditions for both the supplier and the recipient.

A letter of credit is a special bank account that gives the right to reserve the finances on it during trade relations. If both parties comply with the terms of the agreement, the bank must pay a certain amount of money to the recipient.

Where is a letter of credit used?

A letter of credit from a bank in simple words - what is it? We think everything is clear with this question. Now let's find out where it is used. As a rule, these forms of payment are most often used in business: an entrepreneur who has ordered a product can be sure that the funds will be withdrawn from his work account only after shipment. The supplier, in turn, can be sure that he will receive his well-deserved payment. Funds are transferred only when the bank receives the necessary documents. In addition, the letter of credit form of payment is quite often used when concluding large transactions such as purchase and sale.

How does a letter of credit work?

In order to answer this question, you just need to familiarize yourself with the algorithm of actions of the parties who decided to use the form of calculation we are discussing:

1. The supplier declares the opening of a letter of credit in writing, after which a bank account is assigned to it.
2. After receiving the goods, the buyer provides the bank with documents that confirm the fulfillment of the terms of the contract with the supplier.
3. When the above procedures are completed, a pre-agreed amount of money is withdrawn from the buyer's account.

Withdrawals can be made by both the paying bank and the receiving bank.

Letter of credit agreement

In addition to what a letter of credit is in simple words, you also need to know what is necessary for the transaction.

The document that governs the relationship between the parties contains all the information necessary to complete the transaction. The contract stipulates:

• Type of form used.
• Commission cost.
• Participant details.
• Bookable amount of finance.
• Instructions required in case of non-payment of debt.
• Letter of credit terms.
• Payment procedure.
• Rights and obligations of both parties.

Types of letters of credit

There are the following types of letters of credit in the bank:

Covered (deposited)	Most commonly used. Funds are transferred to the recipient bank account from the very beginning
Uncovered	The executing bank is given the right to withhold finances from the correspondent account within the amount of money specified in the agreement
Revocable	The issuer may cancel the transfer of funds if the payer makes a written order. Recipient's consent is not required
Irrevocable	The agreement is canceled only when the seller agrees to this
Confirmed (revocable/irrevocable)	Payments are made by the contractor even if there is no money in the payer’s account
Spare	The bank that opened the account may provide a written commitment to the seller about the payment history in the event that the buyer does not comply with the terms of the agreement. In such a situation, the buyer will fulfill all obligations to the supplier
Revolver	As a rule, it is opened for a portion of the full payment amount, and after the buyer has accrued funds, it is resumed to the previously specified amount. Used in areas where goods are delivered according to a specific schedule
Circular	Gives the right to receive funds under a letter of credit from all correspondents of the advising credit institution
With a red clause	At the direction of the issuer, the advising banking organization credits funds to the seller before he provides documents confirming delivery

Now let's take a closer look at the most popular ones.

Covered and uncovered

Escrowed and guaranteed transactions are the most commonly used letters of credit. The types of contracts determine the specification of the transactions themselves.

1. Covered operation. In this case, when issuing a letter of credit, the issuing bank transfers funds through the payer’s account for the entire amount of the letter of credit. Finances are placed at the complete disposal of the executing bank for the entire duration of the transaction.
2. Uncovered operation. A guaranteed banking transaction involves the transfer of funds by the issuing bank. The executing credit institution is given the opportunity to withdraw funds from its existing account within the value of the letter of credit. The procedure for withdrawing money from an account held with the issuing bank is determined by special agreements between financial institutions.

Revocable and irrevocable

In second place in demand are revocable and irrevocable. They also have their own specific characteristics.

1. Revocable operation. The issuing bank has every right to modernize or completely cancel a revocable banking transaction. The basis for revocation of a letter of credit may be a written order from the payer. In this case, agreement with the recipient of the amount of money is not required. After this procedure, the issuing bank does not bear any responsibility to the payer.
2. Irrevocable operation. An irrevocable letter of credit can only be canceled if the recipient agrees to change the terms of the contract. Partial change of conditions in this situation is not considered.

The recipient of funds under a banking transaction may refuse payment, but until the expiration of its term and provided that this was agreed upon in the agreement. By prior agreement, acceptance by a third party who has the rights of the payer is also permitted.

Advantages and disadvantages

In addition to what a letter of credit is in simple words, many are also interested in the advantages and disadvantages of this phenomenon.

The clear advantages include:

• Legal control of the contract.
• Possibility of receiving excess profits from the buyer's account.
• Reducing the risk of not receiving the amount that was agreed upon in the agreement.
• Guarantee for the buyer to receive delivery on time.
• The right to save on interest payments (which cannot be done with a conventional loan).

If we consider letters of credit objectively, then it is also worth talking about their disadvantages:

• Duration of the contract due to the large number of documents.
• Possibility of restricting the transaction by the state.
• Dear commission.
• Funds are not credited to the recipient's account without providing the documents specified when drawing up the agreement.

Mutual settlements

When concluding a contract, the contract must indicate the form of mutual settlements, as well as the scheme for providing the service or the specifics of the delivery of goods. In addition, the planned types of letters of credit and their features are prescribed in the papers. To avoid problems in the future, the contract should contain the following information:

• Name of the issuing bank.
• Identification data of the recipient of the finance.
• The name of the financial institution that serves the recipient of the money.
• The amount of money in a banking transaction.
• The types that both sides are going to use.
• A method of informing the recipient of funds about the opening of a transaction in the bank.
• Method of informing the payer necessary for depositing money.
• The term of the letter of credit, the deadlines for providing important papers and the rules for their execution.
• Features of payment for the transaction.

Operations on letter of credit transactions

Services for letter of credit transactions can be implemented in different ways, it all depends on the credit institution. As a rule, banks carry out the following operations:

1. Service opening. The bank opens a financial obligation after the client’s application. To implement this obligation, the bank, on behalf of the applicant, must transfer a sum of money in favor of the seller of goods or real estate. On top of that, the issuer may entrust this responsibility to another bank after checking all important papers.
2. Confirmation of commitment. The bank issues a guarantee of payment for a letter of credit that was drawn up by another banking organization.
3. Advising a letter of credit. Notification to a credit institution that a letter of credit has been opened, amended or closed. Official notice is usually sent by letter, fax or any other electronic means of communication. After checking the papers, the bank informs the seller about issuing an invoice for the amount specified in the agreement. Advising is controlled by law, so in order to avoid violations, banks devote a lot of time and effort to this process.
4. Fulfillment of an obligation. The first stage consists of checking the submitted papers from the recipient of the finance. When two banks take part in a transaction, the executing party must advise the issuing bank for payment. This procedure is permissible only if the documents comply with the terms of the contract. If the documents do not meet these conditions, then the obligation is not fulfilled. Payment becomes possible when the buyer agrees to accept documents with defects.

What you should pay attention to?

We have already discussed what a letter of credit is in simple words. Finally, we will focus on a few important points.

For the partnership to be successful, the payer must study this format of banking transactions on his own or with the help of a professional. Letters of credit differ depending on the form of mutual settlements. For a particular case, you need to choose the optimal form of partnership.

A letter of credit is a form of non-cash payments that is understandable in essence, but cumbersome in execution. The main difference between a letter of credit and regular payments from one account to another is the greater participation of banks in the contractual relationship between clients.

It is more convenient to explain what a letter of credit is using examples.

Let’s imagine that the supplier and buyer of a product do not have sufficient trust in each other, but intend to ship the product (provide a service) and pay for it.

For mutual confidence, they involve a third party - a bank - in completing the transaction.

The buyer instructs the bank to transfer money to the supplier after providing documents confirming the shipment of the goods. Such a payer is called applicant, and his bank - issuer .

The bank accepts the obligation and informs the other bank serving the supplier about the terms of the letter of credit.

The supplier (recipient of money), within the framework of the transaction, is defined as beneficiary, provides documents confirming the fulfillment of the obligation to its bank. This bank is called performing.

The beneficiary's bank receives the agreed amount from the correspondent account of the bank that opened the letter of credit.

The bank servicing the payer debits the amount of the letter of credit and the fee for the transaction from his account.

The transaction is considered completed.

Purpose of the letter of credit

In transactions using a letter of credit, a product (service) is transferred from the seller to the buyer. The payment passes from the buyer to the seller. The banks participating in the transfers receive their remuneration for making the payment and providing a guarantee, expressed in accepting responsibility and verifying incoming documents.

The costs of a letter of credit are usually borne by the buyer.

The benefit of banks from issuing letters of credit is greater remuneration than for conventional payments.

The benefit of the supplier is the confidence that his product (service) will be paid for.

The buyer's interest is in transferring the risk of “payment without goods” to the bank. And also the ability to make a transaction without touching your own funds until the transaction is confirmed.

Types and conditions of application of letters of credit

Settlements by letter of credit are often used in international trade or within one state when counterparties have insufficient trust in each other and in the situation.

Letters of credit are professional instruments of interbank relations. Ordinary sellers and buyers do not directly participate in the handling of letters of credit; they only give instructions for their opening and provide documents on transactions. Therefore, it is enough for bank clients to know what guarantees banks offer for letters of credit and the cost of these services.

In practice, it is customary to distinguish the following types of letters of credit:

• Confirmed- here the executing bank agrees to pay the amount of the letter of credit upon the occurrence of the agreed conditions (provision of documents), even if the issuing bank does not make the necessary transfer of funds to it.
• Unconfirmed- if the executing bank does not assume additional obligations.
• Covered- when the amount of the letter of credit from the payer’s bank is transferred to the recipient’s bank account.
• Uncoated- if such a transfer does not occur. Nowadays, most letters of credit are uncovered, because... Banks have each other's correspondent accounts and mutual lines of credit.
• Revolving- such a letter of credit is issued multiple times, in parallel with the delivery and payment of consignments of goods. In demand for regularly recurring transactions.
• Transferable- this option allows the transfer of funds to other beneficiaries.
• Reserve (stand-by)- such letters of credit are paid if the buyer refuses to pay for the shipped goods. This is a form of bank guarantee used in international trade.
• With payment against documents, i.e. after documentary confirmation of delivery.
• Paid with deferment.

This is not a complete list of letters of credit used in global practice. Their choice depends on the needs of clients and the willingness of banks to use certain instruments.

Nowadays, in order for an ordinary person to make any purchase, it is not necessary to have cash in his pocket. Any transaction, including the purchase of real estate, can be paid not only by bank transfer, but also on credit, in installments, or through a bank letter of credit.

At first glance, such a complex concept as “Bank Letter of Credit” is very difficult to understand. But in reality everything is very simple. As statistics show, recently this form of payment has been successfully used not only by legal entities, but also by individuals. So what's the point? Let's figure it out.

So, this article will talk about what a “Bank Letter of Credit” is, what is needed to issue it, and what advantages and disadvantages does it have?

Many financial terms are not only difficult to pronounce, but often difficult to understand. In addition, descriptions of them are given in very confusing language. In order not to find yourself in an awkward situation, and to successfully use the service, we will explain the concept of “Bank Letter of Credit” in a more understandable language.

A bank letter of credit is a kind of protection against risks associated with financial transactions. This is a way to protect yourself and your savings from possible fraudulent activities when concluding contracts. A letter of credit is especially relevant when it comes to prepayments, or transactions are made with new, previously unknown persons who have not yet established themselves as reliable partners.

The essence of a letter of credit is that a special account is opened in a bank in which a pre-agreed amount is reserved. In cases where both parties participating in the auction fulfill all the conditions stipulated by the agreement concluded between them, the bank is obliged to transfer the amount of money in the account to the seller.

In this case, the financial institution acts as a kind of guarantor and assumes responsibility for transferring money to the recipient. A certain fee will be charged for the services provided. It is noteworthy that each bank sets its own prices. For example, as for Sberbank, if a letter of credit is issued between two individuals, its tariffs are 0.2% of the transaction amount, a minimum of 1,500 rubles, a maximum of 5,000 rubles per transaction.

Thus, a bank letter of credit is a form of payment that has, on the one hand, an increased level of security, and on the other, guarantees for both parties to the transaction. It should be noted that thanks to the presence of these two components, the process of transferring, for example, property rights occurs much faster.

Types of Letter of Credit

A bank letter of credit, as it turns out, has several types. They vary depending on the powers of the bank and the number of parties. This information is presented in more detail in the table:

Type of letter of credit	Description
Revocable	This type of letter of credit differs in that the banking institution has the right to close the account unilaterally if there is a written application from the payer. It is issued extremely rarely, since the seller has no guarantees.
Irrevocable	The most common type. In this case, the buyer does not have the opportunity to withdraw funds. And after providing the relevant documents, the seller will receive the money.
Confirmed	This type is most convenient primarily for the buyer. The bank undertakes to transfer the required amount of money to the seller’s account even if there is no money in the payer’s account. Naturally, this increases the bank’s risks, which means an additional commission will be charged.
Unconfirmed	Funds are transferred to the seller's account only when they are received from the buyer.
Coated	Means that the buyer's bank undertakes to transfer funds to the recipient's account within a certain period of time.
Uncovered	During an interbank transfer, funds are first transferred to a correspondent account, and then directly to the recipient’s account. If the letter of credit is not covered, the buyer's bank allows the seller's bank to write off the due money from the correspondent account.
Spare	This type is more reminiscent of a bank guarantee. Its essence is that if the buyer violates the terms of the contract, the bank, at its own expense, undertakes to pay the seller the full amount.
Revolver	The type of letter of credit is most relevant for payments with a fixed schedule. It is not opened for the entire purchase amount, but only for part of it. After the buyer makes a payment, such an agreement will be renewed to the previously agreed upon figure.
With a red clause	According to such an agreement, the buyer's bank can instruct the recipient's bank to transfer funds even before providing documents confirming the fulfillment of the terms of the purchase and sale agreement.

As can be seen from the information presented, there are a whole host of types of bank letters of credit. In order to familiarize yourself with each of them in more detail and choose the one most convenient for you, you should contact the authorized branch of the bank where you plan to draw up the agreement, go to the official website on the Internet, or call the institution’s hotline.

Scheme for issuing a bank letter of credit

After the reader has become more familiar with the letter of credit and has learned its types, it is time to study the sequence of actions that inevitably occur after the corresponding agreement with the bank is signed and the compensation due to him for his work is paid.

The workflow of a letter of credit is as follows:

No.	Action	Note
1	The parties to the transaction enter into an agreement with each other	Such a document must contain detailed clauses about the terms of the transaction. The greatest attention should be paid to the topic of calculation.
2	The buyer chooses a bank and opens an account	The choice of a banking institution should be treated with increased attention. Do not forget that large banks may charge large commissions for their services. However, it is precisely such institutions that have a high level of trust.
3	The buyer deposits funds	The amount that the buyer must deposit into the account must correspond to that agreed in the contract. In another way, this action is called booking funds.
4	The supplier or buyer provides securities to the bank	The essence of this stage is that the second party must submit documents to the bank confirming the fact that the terms of the agreement have been fulfilled in full.
5	Opening a letter of credit account	Letter of credit account is the seller's account number to which the buyer transfers the required amount of money. However, it will open after the bank studies the submitted documentation in detail.
6	Sending notice to buyer	After all the above steps have been completed, the banking institution is obliged to notify the buyer that all conditions have been met by the seller.
7	Funds are being transferred	This operation takes place in strict accordance with the terms of the previously concluded agreement.

Letter of Credit- an obligation of the bank, provided at the request of the client, to pay a third party when the recipient of the payment provides the bank executing the letter of credit with documents provided for by the terms of the letter of credit. The client company on whose behalf the letter of credit is opened is usually called the payer under the letter of credit, or the applicant. The recipient of payment under a letter of credit is called the beneficiary. In this case, the bank’s obligation is independent of the obligations of the parties under the main agreement, which provides for a letter of credit form of payment between the supplier and the buyer. Thus, the bank acts as a guarantor between them.

Suppose a seller and buyer enter into a deal. They are dealing with each other for the first time and are not ready to work on prepayment or pre-delivery. Then the buyer applies to the bank with an application to open a letter of credit for the amount due to the seller for the shipped goods. Evidence of the fulfillment of the contract on the part of the seller can be, for example, documents on the shipment of goods. As soon as the subject of the transaction is transferred to the buyer or an independent carrier, the seller sends the required documents to the executing bank in accordance with the terms of the letter of credit. The buyer's bank makes payment under the letter of credit in accordance with the instructions received from the nominated bank. Letter of credit transactions involve a number of bank commissions, payable in accordance with the terms of the letter of credit. Typically, the fee for opening a letter of credit is paid by the buyer.

Letters of credit allow you to guarantee payment to the supplier, while, as a rule, funds are not diverted from circulation.

The letter of credit form of payment is used both in foreign and domestic trade. Letters of credit used in international payments are subject to the Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce Publication No. 600, as amended 2007 (hereinafter referred to as UCP 600).

Letters of credit used for domestic Russian settlements are subject to Regulations of the Central Bank of the Russian Federation No. 2-P dated October 3, 2002, and from June 9, 2012 - “Regulations on the rules for transferring funds” No. 383-P dated June 19, 2012.

Domestic letters of credit can be classified into the following groups:

Revocable and irrevocable;

Confirmed and unconfirmed;

Covered (escrowed) and guaranteed.

All letters of credit, in accordance with UOP 600, are currently irrevocable. Coverage in international letters of credit is rarely used - only in the case of confirmation of a letter of credit opened by the issuing bank, for which the confirming bank does not set limits.

A confirmed letter of credit is one under which another bank, in addition to the obligation of the issuing bank, undertakes an additional obligation to make a payment in favor of the beneficiary upon presentation by the latter of documents that fully comply with the terms of the letter of credit, regardless of whether the funds will be transferred to it itself or not. If there is no obligation from another bank, then the letter of credit is unconfirmed.

Covered (deposited) - a letter of credit, the amount of which is transferred in full to the cover account in the beneficiary's bank at the expense of the payer or at the expense of the loan provided.

Uncovered (guaranteed) - a letter of credit, upon opening of which the issuing bank does not transfer funds to the letter of credit account in the beneficiary's bank, but gives it the right to write off the required amount within the amount of the letter of credit from its correspondent account or agrees on payment in another way. Typically, large banks have open lines of credit with each other, so in developed countries virtually all letters of credit are classified as uncovered.

In addition, letters of credit are of the following types.

A letter of credit with a red clause is a letter of credit under which the supplier receives a certain amount in the form of an advance before shipping or other documents evidencing the fulfillment of obligations are provided. In this case, the payment is made against the presentation by the beneficiary of the documents provided for by the terms of the letter of credit. The name comes from the times when such an important clause was highlighted in red ink in the document. Of course, nowadays almost all letters of credit are issued and confirmed electronically.

Revolving - a letter of credit opened for a portion of the payment amount and automatically renewed as payments are made for the next batch of goods. Opens with regular deliveries and payments.

Transferable (transferable) - a letter of credit that provides for the possibility of transferring part of the letter of credit in favor of other beneficiaries.

A standby letter of credit, the so-called stand-by, is a form of bank guarantee in the form of a letter of credit, used where banks are prohibited from issuing guarantees (for example, in the USA). Payment to the exporter is made if the importer refuses to make payment under the contract and presents to the executing bank documents that comply with the terms of the standby letter of credit. That is, such a letter of credit serves to ensure greater security for the supplier.

According to the method of execution, letters of credit are divided into letters of credit with payment upon presentation of documents (by payment at sight), with deferred payment and with acceptance of drafts.