A letter of credit is a financial instrument that is commonly used in international commerce when products are being shipped from one country to another. A second common application of letters of credit is in the real estate development world where a developer might have to put up a letter of credit for the city, town, or county to support his promise to develop sidewalks, parks, sewers, or some other common area amenity in exchange for getting the required approvals to build his development.
The letter of credit is put up by a bank, which, by doing so, is certifying that the issuer has the funds available in the bank to pay for the completion of a transaction. Once the letter is issued, if, for any reason the issuer cannot make the payment, the bank is required to cover any shortfall. For example, if a business in the United States is ordering a product that is manufactured in China, the Chinese company might need to hold a letter of credit for the full amount of the payment before it will proceed to manufacture the product. Upon shipping and confirmed receipt of the product by the United States customer, the funds secured by the letter of credit are then released and transferred to the bank of the Chinese manufacturing company. This is often referred to as a standby letter of credit and the funds will remain in place in the bank until confirmation of receipt or until the letter of credit expires.
The most common form of a letter of credit used in commerce is the irrevocable letter of credit. This cannot be canceled and guarantees that the buyer's payment to the seller will be correct and received on time. It will probably be a sight letter of credit, which means that it will be paid once it is presented to the bank along with the necessary documents that are required to confirm performance and receipt. This type of letter of credit requires a more stringent process of verification than an irrevocable letter of credit alone. A red clause letter of credit is written when the buyer extends an unsecured loan to a seller. These are commonly used by beneficiaries who act as purchasing agents for a buyer in another country. The standby letter of credit is more like a guarantee of payment that "stands by" to insure that the buyer will pay the seller. It acts as payment of last resort if the seller cannot secure payment from the buyer after it has completed all of the delivery terms of the shipment order. In that case, the bank will convey the funds to the seller's bank. The standby letter of credit shall have a termination date, usually a year or whatever is reasonable to allow the buyer to make payment and shall be canceled upon confirmation that payment has been made. The cost of a standby letter of credit can be from one percent to eight percent of the total transaction cost, depending on factors including the credit worthiness of the issuer.