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 the Regulation of the Central Bank of the Russian Federation No. 2-P dated October 3, 2002, and from June 9, 2012 - “Regulation on the rules for the transfer of 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 in 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 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 at 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 indicating 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.

A letter of credit is an order from the payer's bank to the recipient's bank

Letter of Credit- this is an order from the payer’s bank, the recipient’s bank, to make payments, by order and at the expense of the client’s funds, to an individual or legal entity within the specified amount and on the terms specified in this order.

When establishing new partnerships between enterprises and organizations, individuals and individual entrepreneurs, the question often arises: How to avoid losing money or goods when concluding a transaction and settlements with an unfamiliar company? How to insure your business against unnecessary and dishonest partners, especially if the contract is for a significant amount? The answer is simple - letters of credit will be used for settlements. Of course, it is quite difficult to learn all the intricacies of working with letters of credit and apply them in calculations, but it gives you a feeling of security. And having studied the letter of credit payment form once, clients rarely refuse it. So, settlement under a letter of credit is carried out under the control of two banks and excludes non-compliance with the terms of concluded contracts, both on the part of the product supplier and on the part of the buyer.
Letter of Credit– this is the safest form of payment between clients. There was a case in my practice when the majority of consumers of caustic soda from a large chemical plant switched to settlements with it through a letter of credit. At that time, Khimzavod, being the only caustic soda producer in the post-Soviet space, was on the verge of bankruptcy, but continued to operate and ship products. The crediting of money to the current account from the letter of credit received by the bank was carried out by the bank after the products were shipped and all shipping documents were submitted to the bank in accordance with the contract and the payer’s instructions. All documents were carefully checked. The letter of credit gave confidence to consumers (payers) that if the products were not shipped on time, the funds would be returned by the supplier’s bank without problems or delays. And the plant, being in a “financial hole,” was sure that another consumer would not abandon it without payment.

Letter of Credit- this is a settlement document, on paper, on the basis of which the bank, acting on behalf of the payer to open a letter of credit (hereinafter referred to as the issuing bank), undertakes to make payments in favor of the recipient of funds upon presentation by the latter of documents that meet all the conditions of the letter of credit, or to provide authority to another bank (hereinafter referred to as the executing bank) to make such payments.

Non-cash payments using letters of credit are carried out on the basis of the following regulations:

• Regulations of the Central Bank of the Russian Federation dated October 3, 2002 N 2 - “Regulations on non-cash payments in the Russian Federation”


• Regulations of the Central Bank of the Russian Federation dated April 1, 2003 N 222-P - “Regulations on the procedure for making non-cash payments by individuals in the Russian Federation”


• Civil Code of the Russian Federation (Civil Code of the Russian Federation) dated January 26, 1996 N 14-FZ - Part 2 of Article 867 - 873

Types of letters of credit

When making payments using letters of credit, it is very important to choose the right type of letter of credit. The opening of a letter of credit is carried out by banks on behalf of the payer, therefore, the type of letter of credit, as a rule, is proposed by the payer in the draft agreement.

In accordance with the Regulations of the Central Bank of the Russian Federation, banks can open the following types of letters of credit:

• covered (deposited) letter of credit;
• uncovered (guaranteed) letter of credit;
• revocable letter of credit;
• irrevocable letter of credit;
• confirmed letter of credit (revocable or irrevocable).

Covered letter of credit (deposited)– this is when, when opening a letter of credit, the issuing bank transfers, at the expense of the payer’s funds, the amount of the letter of credit (coverage) at the disposal of the executing bank for the entire validity period of the letter of credit.

Uncovered letter of credit (guaranteed)- this is when, when opening a letter of credit, the issuing bank does not transfer funds, but gives the executing bank the right to write off funds from the correspondent account maintained by it within the amount of the letter of credit. The procedure for writing off funds from the correspondent account of the issuing bank under a guaranteed letter of credit is determined by agreement between the banks.

Revocable letter of credit- this is a letter of credit that can be changed or canceled by the issuing bank on the basis of a written order of the payer without prior agreement with the recipient of funds and without any obligations of the issuing bank to the recipient of funds after the letter of credit is revoked.

Irrevocable letter of credit is a letter of credit that can be canceled only from the moment the executing bank receives the consent of the recipient of funds to change the conditions. Partial acceptance of changes to the terms of an irrevocable letter of credit by the recipient of funds is not permitted.

Confirmed letter of credit (revocable or irrevocable)- this is a letter of credit, upon execution of which the executing bank undertakes to pay the amount specified in it, regardless of the receipt of funds from the bank where the confirmed letter of credit was opened. The confirmation procedure is determined by agreement between the banks.

Currently, there are several other types of letters of credit, which are variations of those described above:

• Letter of credit with red clause- this is a letter of credit, according to which the issuing bank authorizes the executing bank to make an advance payment to the supplier of the goods (the beneficiary - the recipient of the funds) in a specifically agreed amount before the submission of all trade documents, that is, before the shipment of the goods or the provision of services.
• Revolving letter of credit- this is a letter of credit opened for a portion of payments from the total amount under the contract, automatically renewed as payments are made for the next batch of goods. A revolving letter of credit is opened for uniform deliveries spread over time, with the goal of cyclically reducing the contract amount.

The recipient of funds under a letter of credit may refuse to use the letter of credit before its expiration, if the possibility of such refusal is provided for by the terms of the letter of credit. In addition, the terms of the letter of credit may provide for acceptance by a person authorized by the payer.

Payments using letters of credit

Non-cash payments for services rendered, delivery of goods or performance of work are prescribed in contracts, and the form of payment is also prescribed there.
When using a letter of credit form of payment, the contract must reflect the following conditions:

• name of the issuing bank,
• name of the bank serving the recipient of funds,
• name of the recipient of funds,
• letter of credit amount,
• type of letter of credit,
• method of notifying the recipient of funds about the opening of a letter of credit,
• method of notifying the payer about the account number for depositing funds opened by the executing bank,
• validity period of the letter of credit, submission of documents confirming the supply of goods (performance of work, provision of services), and requirements for the execution of these documents;
• terms of payment (with or without acceptance);
• liability for non-fulfillment (improper fulfillment) of obligations.

The agreement may also include other conditions relating to the procedure for settlements under the letter of credit. For example, partial payments under a letter of credit are allowed.

Payment under a letter of credit is made by bank transfer by transferring the amount of the letter of credit to the account of the recipient of the funds.

And most importantly, banks are responsible for violations committed during the execution of the letter of credit payment form in accordance with the law. Taking this into account, it becomes clear that it is not profitable for the executing bank to accept unfinished documents confirming the delivery of goods, performance of work or provision of services.

A letter of credit is a conditional obligation of the bank to make, at the request of the client, payments to individuals and organizations at his expense within the amount and conditions that were agreed upon in advance.

A letter of credit is a transaction that is carried out between one or more financial institutions in a non-cash form. The basis for the operation is a specialized application, which is drawn up in the prescribed form and submitted by the buyer in favor of the supplier of the service or product. The parties involved can be only individuals, only legal entities, or both individuals and legal entities.

What is a letter of credit in simple terms? This is a very convenient form of interaction, which, however, is rarely used due to its complexity. A letter of credit is a form of payment that guarantees payment for the supplier and fulfillment of the terms of the contract for the buyer. After delivery of a product or provision of a service, the bank pays the seller its cost. The buyer, in turn, returns the funds to the bank, including interest.

The letter of credit form of payment can be used not only in domestic trade, but also in foreign trade. When applied in international trade, the procedure is governed by the Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce Publication No. 600, as amended 2007.

Very often, a letter of credit is compared with a bank guarantee and factoring, however, these concepts are similar only at first glance. Learn more about the letter of credit in the video below.

What is a letter of credit: features of banking services

The use of this form of payment began to develop in Soviet times. OJSC Bashkir Soda Company, which produces caustic soda and is on the verge of bankruptcy, switched to a letter of credit form of interaction with clients in order to still continue its activities.

Funds were credited only after the company provided the bank with documents confirming the fulfillment of the terms of the contract, which were carefully checked. In this example, it can be seen that the letter of credit provided certainty to both parties.

Calculation scheme

Participants in settlements:

• a bank client who uses the service of opening a letter of credit;
• the issuing bank or organization that undertakes the opening obligations;
• executing bank - the organization making payments;
• the individual or legal entity in whose favor the letter of credit was opened.

The letter of credit scheme is quite simple. It includes several mandatory steps:

1. At the initial stage, the buyer and seller enter into an agreement for the supply of products or provision of services.
2. The buyer contacts the bank, where he fills out an application to open a letter of credit. The application is drawn up in the prescribed form.
3. The issuing bank notifies the bank that services the seller about the opening in his name.
4. The executing bank, in turn, notifies the seller.
5. The seller delivers goods or provides services.
6. The seller notifies the executing bank that its obligations to the buyer have been fulfilled.
7. The executing bank makes payment in favor of the seller in the agreed amount.
8. The executing bank notifies the issuing bank of the payment to the seller.
9. The issuing bank, in turn, compensates the payment to the executing bank.
10. Payment documents are transferred to the buyer.
11. The buyer studies the documentation and signs an agreement to pay funds to the issuing bank.
12. Withdrawal of funds from the buyer's account and crediting them to the bank.

The service is provided by the issuing bank on the basis of an application, drawing up an agreement on form 0401063. This document guarantees the supplier that the product or service will be paid for within the agreed time frame. The buyer's funds may not be provided at the end of the algorithm; they may be deposited in advance.

Agreement: drafting, conditions, form

A well-drafted contract includes the following points:

• names of banks, cooperating organizations or full names and passport details of individuals;
• the amount of the letter of credit payment for the services or products provided;
• letter of credit form of payment - non-cash or the use of cash is not allowed;
• methods of notifying parties to the agreement;
• the period during which the contract is valid. During this period, the terms of the agreement between the buyer and the seller must be fulfilled, payment must be made, and all documents must be submitted;
• liability of the parties that will result from failure to fulfill obligations in accordance with this legislation.

The standard list of conditions indicated above may be supplemented with additions regarding the procedure for making calculations. For example, not a full payment, but a share payment may be used. A letter of credit can be issued for payment to one individual or organization. However, the person through whose funds the payment will be made can be changed if this is specified in the contract - the possibility of acceptance.

Types of Letter of Credit

When using this form of mutual settlement, a very important point is the selection of the appropriate type of letter of credit. Any variety is opened by financial institutions, and the type is indicated in the agreement. The types are prescribed in the Regulations of the Central Bank of the Russian Federation:

• According to the type of settlements of financial organizations - covered and uncovered. In the first case, the issuing bank makes cash payments at the expense of its client’s funds in favor of the executor’s bank for the entire duration of the agreement. In the second, the transfer of funds from one financial organization to another is not carried out. At the same time, the executing bank has the opportunity to write off funds within the agreed amount, after which this is compensated by the issuing bank.
• If possible, recall - revocable and irrevocable. In the first case, the form of interaction can be changed or rejected without prior agreement with the opposite party, in the second - only with agreement.
• Confirmed or unconfirmed. In the first case, payments are possible without agreement with the issuing bank and receipt of funds from it.

Legal regulation

The letter of credit agreement is clearly regulated by this legislation of the Russian Federation and is drawn up according to the rules prescribed in the regulatory documents of the Central Bank of the Russian Federation in the event that the agreement is drawn up between domestic organizations or residents of the Russian Federation.

The following regulations must be taken into account:

• Articles of the Civil Code of the Russian Federation from 867 to 873, which regulate non-cash payments under a letter of credit;
• “Regulations on the implementation of non-cash transfers by individuals in the Russian Federation”, adopted by the Central Bank on April 1, 2003;
• “Regulations on non-cash payments” established by the Central Bank of Russia on October 3, 2012.

It is worth considering that the organization in whose favor the letter of credit payment is issued has the right to refuse this form of payment.

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 to complete 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 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 before 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.