Global trade and finance is a very sensitive industry; trust and security between involved parties are one of the most important factors in this industry. A simple handshake is no longer safe or practical when you are dealing with large amounts of money, and deals are made over vast distances.
This is the reason why tools like the standby letter of credit (SBLC) are invaluable in the modern trade world. It provides assurances in large commercial transactions.
It is quite different from the standard letter of credit; an SBLC ensures the financial obligations will be honored only if the other party defaults on payment.
In this article, we will look at the standby letters of credit, explaining its use case, its differences from other financial tools, and why it is necessary for trade.
What Is a Letter of Credit?
An LC is often also referred to as a commercial LC, as it functions like a direct and expected payment mechanism. It means to facilitate normal payment for goods.
The party having a commercial LC for their benefit, like a seller, for example, can present the receipts of the translation, like the bill of lading, to the bank after shipping the goods. If the documents are compliant with the contract terms discussed in the LC, the seller’s bank will promptly release payment to the seller.
What Is a Standby Letter of Credit?
In simple terms, an SBLC in the context of finance and trade is a bank’s guarantee to pay the beneficiary when the client defaults on their agreed-upon contract.
If an applicant has acted suspiciously or isn’t well known by the other party, an SBLC is issued to protect the seller from fraud or being taken advantage of due to the different legal landscape of another country.
A standby letter of credit can be thought of as a safety net that only comes into play when there is a specific problem or non-performance. Under normal circumstances, where the contract goes smoothly, an SBLC does not work. It is not meant as a method of payment for the goods or services, but more of a secondary payment option as a last resort.
The SBLC is therefore a backup that allows the beneficiary to confidently enter into agreements where there is perceived to be a higher risk or uncertainty.
A good example of where an SBLC should be used is when a manufacturer of machinery is planning to dispatch a huge order to an unfamiliar international client.
Inclusion of an SBLC in the terms of agreement can provide the seller a profound sense of security in case their client refuses to pay.
Difference between SBLC and LC
An SBLC and a traditional letter of credit (LC) are both used by banks to provide security for large-scale commercial transactions; however, they have significant differences from each other in terms of how they are used.
The fundamental purpose of an LC is to provide the beneficiary with the assurance that the payment of goods will happen if they complete the contract. The key point here is that an LC can be used to get paid by the buyer’s bank if the contract doesn’t have any default issues.
Essentially, the commercial LC is like a routine payment method used for trade transactions between different countries.
The SBLC does not serve as a payment method. It operates as an insurance policy for the seller, helpful for securing payment in case of a default. It is only invoked if a party fails to meet its financial obligations.
In trade, SBLCs are often used instead of, not alongside commercial LCs. They are used when the buyer and seller plan to handle payment directly, but the seller still wants the security of a bank guarantee in case the buyer doesn’t pay.
How Does a Standby Letter of Credit Work?
Different from a direct payment method, the SBLC works as a contingent guarantee for the seller and only comes into play if the buyer is not complying with the contract terms.
The process begins when an applicant, such as the buyer, contractor, or service provider, reaches out to a bank to provide a guarantee of performance.
The party requests the bank to issue a standby letter of credit by providing detailed information about the contract. This includes the specific obligation to be guaranteed, like the delivery of goods or the completion of a project, and the underlying amount of the SBLC, along with its expiry date.
The bank then determines if the amount can indeed be repaid by the party. This involves a detailed assessment of the applicant’s creditworthiness, operational capacity, and financial stability. The bank also requests collateral in case the buyer’s creditworthiness or ability to pay is in question.
Once the bank is satisfied, it will formally issue the SBLC to the beneficiary, which is the seller. The SBLC specifies the exact conditions under which the beneficiary can make a claim.
If the buyer abides by the contract and its obligations before the due date, the SBLC will be terminated without incurring further charges to the buyer.
However, in case there is a default on the payment in the specified period of the SBLC, the beneficiary can make a claim from the bank by providing supporting documentation to prove the other party’s default.
SBLC Fees and Requirements
An SBLC comes with its own set of requirements and fees. It is therefore critical to first understand the costs associated with requesting standby letters of credit.
Since the bank takes over a significant portion of the liability on behalf of the beneficiary, the bank often requires collateral from the applicant. Collateral for the payment is usually in the form of cash deposits, marketable equities like stocks or bonds, or other assets.
The bank’s lending policy determines the magnitude of the collateral needed based on the applicant’s financial history and the current economic strength of their source of income.
In cases of SBLC, banks also charge a fee for the initial issuance and a recurring charge for the duration of the SBLC maintenance. The initial fee for the SBLC is related to the total amount of the SBLC, the creditworthiness of the applicant, or other factors like conditions of the beneficiary’s country, according to the bank’s own assessment. It is usually a small percentage of the total value of the SBLC, ranging from 0.25 percent to 1 percent, and some other banks charge a flat fee.
Once the issuance fee is paid and the SBLC becomes active, the bank will start charging a service fee of 1-10 percent yearly until the SBLC expires.
There is also an annual interest charged based on the determined liability that is usually within a 2-6 percent range, depending on the bank’s increasing cost in maintaining the SBLC.
Conclusion
The standby letter of credit enables global businesses to make large-scale contracts with less risk. It is an important financial instrument that works in a vastly different capacity than a traditional LC. Knowing when and how to use it is important for any business that deals with international commerce.
Frequently Asked Questions (FAQs)
What is the difference between a standby letter of credit and a revolving letter of credit?
SBLC is a contingent guarantee for non-performance or default in a contract, only meant to be relied on if something goes wrong.
A revolving letter of credit (RLC) is used for ongoing, repeated shipments or orders over a set time period. You keep using it while you hope you never have to use the SBLC.
Who uses SBLC?
SBLC is used by parties that need a financial guarantee against a default in a contract. It is mostly used by importers and exporters, or buyers with lower creditworthiness.
What is the irrevocable standby letter of credit?
Once the irrevocable SBLC is issued by the bank, it cannot be canceled or amended without the consent of all parties. This provides the highest security for the seller.
SBLC is a contingent guarantee for non-performance or default in a contract, only meant to be relied on if something goes wrong.
A revolving letter of credit (RLC) is used for ongoing, repeated shipments or orders over a set time period. You keep using it while you hope you never have to use the SBLC.
SBLC is used by parties that need a financial guarantee against a default in a contract. It is mostly used by importers and exporters, or buyers with lower creditworthiness.
Once the irrevocable SBLC is issued by the bank, it cannot be canceled or amended without the consent of all parties. This provides the highest security for the seller.
