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DEFINITION of 'Standby Letter of Credit - SLOC' A guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party.

When to use a letter of credit

Although letters of credit can be useful, it’s often best to avoid using one for a transaction. They can sometimes result in expensive delays, bureaucracy and unexpected costs. As a general rule you should probably only consider opening a letter of credit as an importer if:

• your supplier insists on it
• national exchange controls require it

Exporters - deciding whether to ask for a letter of credit

Think carefully about whether or not you need to ask an overseas customer for a letter of credit. Some important things to consider include:

• Legal matters - does the country you’re exporting to require one?
• Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?
• The customer’s creditworthiness - do they have a track record with you?
• Risks associated with the country you’re exporting to - is it politically stable with a good reputation as an international trading partner?
• Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
• Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.

Give some thought to alternative arrangements, such as credit insurance, export factoring or cash in advance terms.
If you do decide that a letter of credit is the best option you’ll need to consider which type of letter to use. A ‘confirmed and irrevocable’ letter of credit is the most secure type.
It’s wise to have a clear policy in your business about when to consider using a letter of credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily and possibly putting off would-be customers.

Types of letter of credit

There are five commonly used types of letter of credit. Each has different features and some are more secure than others. The most common types are:

• irrevocable
• revocable
• unconfirmed
• confirmed
• transferable

Other types include:

• standby
• revolving
• back-to-back

Sometimes a letter of credit may combine two types, such as ‘confirmed’ and ‘irrevocable’.

Irrevocable and revocable letters of credit

A revocable letter of credit can be changed or cancelled by the bank that issued it at any time and for any reason.
An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.

Confirmed and unconfirmed letters of credit

When a buyer arranges a letter of credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in their country to check that the letter of credit is valid.
For extra security, the seller may require the letter of credit to be ‘confirmed’ by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. So a confirmed letter of credit provides more security than an unconfirmed one.

Transferable letters of credit

A transferable letter of credit can be passed from one ‘beneficiary’ (person receiving payment) to others. They’re commonly used when intermediaries are involved in a transaction.

Standby letters of credit

A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn’t expect to have to draw on the letter of credit to get paid.

Revolving letters of credit

A single revolving letter of credit can cover several transactions between the same buyer and seller.

Back-to-back letters of credit

Back-to-back letters of credit may be used when an intermediary is involved but a transferable letter of credit is unsuitable.

Uniform customs and practice for documentary credit

To standardise terms and procedures and avoid misunderstandings, a set of international rules for letters of credit have been developed by the International Chamber of Commerce (ICC).
Most commercial letters of credit are governed by these rules, which are referred to as Uniform Customs and Practice for Documentary Credits (UCP). The current version of the rules is UCP 600, which came into effect on 1 July 2007.
The UCP standards give definitions of important terms that are used in letters of credit. When referring to letters of credit, banks and others involved in international trade will generally use the UCP definitions of key terms and phrases.
UCP also sets out general documentary requirements and standard practices for handling letters of credit.
The ICC publishes a number of guides on UCP 600. You can find available publications about UCP 600 on the ICC Bookshop website.

Using UCP 600 letters of credit

Because UCP 600 standards are internationally recognised it’s always best to use letters of credit that are covered by them. If you’re an importer you may well find that sellers require you to use UCP letters of credit.
If a letter of credit is subject to UCP it will state this somewhere on it. It might include a statement like ‘This letter of credit is subject to the latest version of Uniform Customs and Practice for Documentary Credits published and updated by the International Chamber of Commerce’.
Be aware that in some instances the definitions and procedures set out in the UCP standards may differ from the laws of a particular country.

Understanding and Using Letters of Credit

Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism.

Commercial Letter of Credit
Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves.

Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payor.

Elements of a Letter of Credit

• A payment undertaking given by a bank (issuing bank)
  
• On behalf of a buyer (applicant)
  
• To pay a seller (beneficiary) for a given amount of money
  
• On presentation of specified documents representing the supply of goods
  
• Within specified time limits
  
• Documents must conform to terms and conditions set out in the letter of credit
  
• Documents to be presented at a specified place