Letters of Credit: Types and Parties

Why This Topic Matters

Letters of credit (L/Cs) sit at the intersection of several CTP exam domains: working capital and trade finance, bank relationship management, credit and liquidity, and risk management. A treasurer uses L/Cs to make cross-border sales possible, to protect against counterparty and country risk, to enhance the credit quality of debt issues such as commercial paper, and to support performance obligations without tying up cash. Because an L/C consumes bank credit capacity and generates fees, it also directly affects corporate liquidity management, which is why the AFP places it in this section of the body of knowledge. On the exam you can expect questions that test whether you can name the parties and their obligations, distinguish among L/C types, and explain how the choice of L/C shifts risk and cost between buyer, seller, and banks.

What a Letter of Credit Is

A letter of credit is a written undertaking by a bank (the issuing bank), issued at the request of its customer (the applicant), to pay a stated sum to a third party (the beneficiary) upon presentation of documents that strictly comply with the terms and conditions of the credit, within a stated time frame. Three principles define the instrument:

1. Independence principle – The L/C is a separate contract from the underlying sales contract. The bank deals in documents, not in goods or services. If the documents comply, the bank must pay even if the goods are defective; if the documents do not comply, the bank may refuse even if the goods are perfect.
2. Strict compliance – Documents must conform exactly to the credit terms. Minor discrepancies (misspellings, late shipment, inconsistent quantities) are grounds for refusal.
3. Bank credit substitution – The seller substitutes the credit standing of a bank for the credit standing of an unknown buyer.

Commercial L/Cs are governed by the ICC Uniform Customs and Practice for Documentary Credits (UCP 600). Standby L/Cs are usually governed by ISP98 (International Standby Practices), although they may also be issued under UCP 600. Under UCP 600, every credit is irrevocable even if it does not say so.

The Parties to a Letter of Credit

Applicant (account party) – The buyer or importer who requests the L/C from its bank and is ultimately obligated to reimburse the issuing bank. The applicant uses part of its bank credit line and typically pays issuance and amendment fees.

Beneficiary – The seller or exporter in whose favor the L/C is issued and who receives payment upon presenting complying documents.

Issuing (opening) bank – The applicant's bank, which issues the credit and makes the primary, irrevocable undertaking to pay. It bears the applicant's credit risk.

Advising bank – Usually a bank in the beneficiary's country that authenticates the L/C and forwards it to the beneficiary. The advising bank has no payment obligation; it only verifies the apparent authenticity of the credit.

Confirming bank – A bank (often the advising bank) that adds its own irrevocable undertaking to pay, in addition to that of the issuing bank. Confirmation protects the beneficiary against the credit risk of the issuing bank and the political/transfer risk of the issuing bank's country. The beneficiary or applicant pays a confirmation fee.

Nominated bank – A bank authorized by the issuing bank to pay, accept drafts, incur a deferred payment undertaking, or negotiate. A freely negotiable credit makes any bank a nominated bank.

Negotiating bank – A bank that purchases (advances funds against) the beneficiary's draft and documents before receiving reimbursement from the issuing bank, typically with recourse to the beneficiary unless it has confirmed the credit.

Paying or accepting bank – The bank designated to pay a sight draft or accept a time draft. When a bank accepts a time draft drawn under an L/C, the result is a banker's acceptance, a negotiable money-market instrument that can be discounted for immediate cash.

Reimbursing bank – A bank holding the issuing bank's funds that reimburses the paying or negotiating bank on the issuing bank's instructions.

Types of Letters of Credit

By purpose
• Commercial (documentary) L/C – The primary payment mechanism for a trade transaction. The parties expect it to be drawn upon. Documents typically include a draft, commercial invoice, bill of lading, insurance certificate, packing list, and certificate of origin.
• Standby L/C – A backup guarantee of payment or performance. The parties expect it not to be drawn; it is drawn only upon default, usually against a simple statement of non-performance. Standby subtypes include performance standbys, financial standbys (e.g., backing commercial paper, bonds, lease payments, or workers' compensation self-insurance), advance-payment standbys, bid-bond standbys, and direct-pay standbys (where the bank pays regularly scheduled amounts and is reimbursed by the applicant, commonly used with variable-rate demand bonds). Standbys are a form of credit enhancement and appear off-balance-sheet as contingent liabilities, but they count against the applicant's credit lines.

By revocability
• Irrevocable – Cannot be amended or canceled without the agreement of the issuing bank, the confirming bank (if any), and the beneficiary. Standard under UCP 600.
• Revocable – Can be changed or canceled by the issuing bank without notice to the beneficiary. Offers almost no protection and is rarely used; UCP 600 does not provide for it.

By confirmation
• Unconfirmed (advised) – Only the issuing bank is obligated; the beneficiary bears issuing-bank and country risk.
• Confirmed – A second bank adds its undertaking; the beneficiary can look to a bank in its own country and is protected against issuing-bank insolvency and foreign exchange controls or political events. Confirmation is more costly.

By timing of payment
• Sight L/C – Payment is made upon presentation of complying documents (in practice within five banking days under UCP 600).
• Usance (time/term) L/C – Payment is made at a future date, e.g., 90 days after sight or after the bill-of-lading date. May be structured as an acceptance credit (a time draft accepted by a bank creates a banker's acceptance) or a deferred payment credit (no draft). Usance credits give the buyer financing; the seller can discount the acceptance for immediate cash.

Special structures
• Transferable L/C – The first beneficiary (often an intermediary or broker) may transfer all or part of the credit to one or more second beneficiaries (the actual suppliers). The credit must expressly state that it is transferable, and it may be transferred only once.
• Back-to-back L/C – An intermediary uses an L/C received from its buyer as collateral to have its own bank issue a second L/C to its supplier. Unlike a transferable L/C, these are two separate credits.
• Revolving L/C – Automatically reinstates for a set amount over a period (by time or by value), useful for repeated shipments to the same buyer; it may be cumulative or non-cumulative.
• Red clause L/C – Permits the beneficiary to draw an advance (historically written in red ink) before shipment to finance procurement or production; green clause credits extend this to cover warehousing and insurance.
• Evergreen clause – Common in standbys; the credit automatically renews unless the issuing bank gives notice of non-renewal, which lets the beneficiary draw before expiry.
• Straight vs. negotiable L/C – A straight credit is payable only at the issuing or paying bank; a negotiable credit allows any bank to negotiate the documents.

How a Commercial L/C Works – Step by Step

1. Buyer and seller sign a sales contract specifying payment by L/C.
2. The buyer (applicant) applies to its bank; the bank evaluates the buyer's credit and may require collateral or use of an existing line.
3. The issuing bank issues the L/C (usually via SWIFT MT700) and sends it to an advising bank in the seller's country.
4. The advising bank authenticates the credit and advises the beneficiary; if requested, it adds its confirmation.
5. The seller ships the goods and assembles the required documents.
6. The seller presents the documents and draft to the nominated/confirming bank within the presentation period (default 21 days after shipment under UCP 600, and before expiry).
7. The bank examines the documents for strict compliance. If compliant, it pays (sight), accepts (usance), or negotiates, then forwards documents to the issuing bank for reimbursement.
8. The issuing bank examines the documents, debits the applicant's account or line, and releases documents so the buyer can claim the goods.
9. If discrepancies exist, the bank notifies the presenter; the applicant may waive them, or documents may be returned or sent on approval (collection basis), which removes the bank's payment undertaking.

Liquidity and Cost Implications for the Treasurer

• L/Cs use bank credit capacity; a large standby program can crowd out borrowing availability.
• Fees include issuance, amendment, confirmation, negotiation, discrepancy, and commitment or annual standby fees (often quoted in basis points per annum on the face amount, priced like a loan to the applicant's credit rating).
• A standby L/C backing commercial paper lets a lower-rated issuer borrow at near the rating of the issuing bank, lowering interest cost but adding L/C fees – the treasurer compares total all-in cost.
• For the seller, a confirmed sight L/C converts a foreign receivable into near-cash and may allow the receivable to be excluded from the credit-risk reserve; a usance L/C can be discounted (forfaited) to accelerate cash flow.
• For the buyer, a usance L/C is a form of trade financing that extends days payable outstanding without harming the supplier relationship.
• L/Cs are generally more expensive and document-intensive than open account or documentary collections but far safer than open account when the counterparty or country is unfamiliar.

Exam Tips: Answering Questions on Letters of Credit: Types and Parties

1. Anchor on the four core parties and who bears risk. Applicant = buyer, beneficiary = seller, issuing bank = primary obligor, advising bank = messenger with no payment duty. If a question asks which party has no obligation to pay, the answer is almost always the advising bank.

2. Confirmation is about the beneficiary's risk. When a question mentions concern about the issuing bank's creditworthiness, political instability, or currency controls in the buyer's country, the answer is a confirmed L/C. Confirmation adds a second irrevocable undertaking; it does not change the applicant's obligation.

3. Standby vs. commercial is about expectation of drawing. Commercial = expected to be drawn as the payment method for a trade. Standby = backup, drawn only on default, used for credit enhancement (commercial paper, bonds, self-insurance), performance guarantees, and bid or advance-payment security. If the stem says 'support a commercial paper program' or 'guarantee performance', pick standby.

4. Irrevocable is the default. Under UCP 600 a credit is irrevocable unless stated otherwise, and any amendment requires beneficiary consent. Revocable credits are a classic distractor.

5. Know the financing link. A time draft accepted by a bank under a usance L/C becomes a banker's acceptance, a money-market instrument. Sight = pay now; usance = pay later; deferred payment = usance without a draft.

6. Transferable vs. back-to-back. Transferable is one credit passed (once) to a second beneficiary and must be labeled transferable. Back-to-back is two separate credits where the first is collateral for the second. Both are intermediary structures; red/green clause credits are pre-shipment financing; revolving credits are for repetitive shipments.

7. Remember the documents-not-goods rule. If a question describes a bank refusing payment because of a spelling error on the invoice, or paying despite defective goods, it is testing the independence principle and strict compliance. Banks never inspect merchandise.

8. Watch for liquidity angles. The CTP exam often asks why a treasurer would choose an L/C: for the seller, to reduce credit and country risk and accelerate cash conversion; for the buyer, to obtain financing or to persuade a supplier to ship. Also recall that standby L/Cs reduce available credit under bank lines and are disclosed as contingent liabilities.

9. Compare payment methods on a risk spectrum. From the seller's view, safest to riskiest: cash in advance, confirmed L/C, unconfirmed L/C, documentary collection (D/P then D/A), open account. From the buyer's view the order reverses. Expect at least one question placing L/Cs on this spectrum.

10. Eliminate distractors by matching role to action. Issuing bank issues and reimburses; advising bank authenticates; confirming bank guarantees; negotiating bank buys documents; reimbursing bank settles between banks. Match the verb in the question to the bank name and most party questions become straightforward.

Quick Recap

A letter of credit replaces buyer credit risk with bank credit risk, is independent of the underlying sale, and is paid only against strictly compliant documents. Master the parties (applicant, beneficiary, issuing, advising, confirming, nominated/negotiating, reimbursing), the classifications (commercial vs. standby, irrevocable vs. revocable, confirmed vs. unconfirmed, sight vs. usance, transferable, back-to-back, revolving, red clause, evergreen), and the liquidity trade-offs (fees and credit-line usage versus risk reduction and financing), and you will be well prepared for every L/C question on the CTP exam.