Standby Letter of Credit vs. Letter of Credit: Which One Is Right for Your Business Needs?

When it comes to securing business transactions, letters of credit (LCs) play a crucial role in building trust between buyers and sellers. But not all LCs are the same. If you’re navigating international trade, contract agreements, or financial guarantees, you may have come across two common types: the Standby Letter of Credit (SBLC) and the traditional Letter of Credit (LC). While they might sound similar, they serve very different purposes.

Understanding the key differences between these financial instruments can help you determine which one best suits your business needs. In this article, we’ll break down how SBLCs and LCs work, their unique advantages, and when to use each one.

Understanding Letters of Credit in International Transactions

A letter of credit is a financial instrument issued by a bank guaranteeing payment to a seller. It ensures that the seller receives payment if specific conditions are met. This reduces risks for both buyers and sellers in international transactions.

Letters of credit are used in a wide range of industries, from manufacturing to technology. They facilitate commercial transactions by providing a guarantee that funds will be available when needed. This makes them an essential tool for businesses looking to expand globally.

Standby Letter of Credit

A standby letter of credit acts as a backup payment mechanism. It’s used when the buyer fails to fulfill their payment obligations. The issuing bank steps in to guarantee payment, offering assurance to the beneficiary.

Standby letters are often used as a form of insurance in business transactions. They are not intended to be used unless something goes wrong. This makes them different from regular letters of credit, which are designed to facilitate payment as part of the deal.

Key Features of a Standby Letter of Credit

• Acts as a secondary guarantee if the buyer defaults.
• Often used in construction projects, leasing agreements, and service contracts.
• Provides financial security without being the primary payment method.

The standby letter of credit is a versatile tool. It can be used to secure loans, support contractual obligations, and provide assurance in high-value transactions. Businesses often rely on them to enhance their credibility in international trade.

Confirmed or Documentary Letter of Credit

A confirmed letter of credit includes an additional guarantee from a second bank. This ensures payment even if the issuing bank or buyer defaults. It’s commonly used in high-risk international trade deals.

Confirmed letters of credit are particularly useful in volatile markets. They provide an extra layer of security for exporters dealing with new or less reliable buyers. The confirmation from a second bank reduces the risk of non-payment.

Key Features of a Documentary Letter of Credit

• Provides double assurance with two banks guaranteeing payment.
• Beneficial for sellers dealing with unfamiliar buyers or unstable markets.
• Reduces payment risks significantly.

Having a confirmed letter of credit can make negotiations easier. Sellers feel more confident when they know that a reputable bank backs the payment. This can lead to better terms and stronger business relationships.

Standby Letter of Credit vs. Letter of Credit: Key Differences

Although both serve as financial guarantees, they function differently and are used in distinct business scenarios. Below, we break down their key differences:

• Purpose: A standby letter of credit is a safety net, while a commercial letter of credit is the primary payment method. The standby letter offers a secondary guarantee, ensuring payment if the buyer defaults, while a commercial letter facilitates full payment directly.
• Usage: Standby letters are common in service contracts and construction projects, providing financial security. Commercial letters are standard in goods trade, ensuring full payment before shipping. Red clause letters allow advance payments, offering flexibility in transactions.
• Trigger for Payment: A standby letter is triggered if the buyer defaults on obligations, acting as a backup payment mechanism. A commercial letter pays when specific conditions are met, such as document submission. Removing letters simplifies processes by reducing conditions.

The main difference lies in how and when they are used. A standby letter provides assurance if needed, while a commercial letter ensures full payment as part of the payment process from the start. Our Suisse Bank offers trade finance solutions, including standby letters of credit and documentary letters of credit, ensuring financial security and flexibility for international transactions.

Payment Process and Obligations

For a standby letter, payment occurs only if the buyer fails to pay. In a commercial letter of credit, payment is made when the seller presents the required documents proving the transaction.

The issuing bank plays a crucial role in both types. All conditions must be verified before releasing funds. This process helps protect both parties in the transaction.

Use Cases in International Trade

• Standby Letter: Commonly used in long-term contracts, construction projects, and service agreements where financial security is essential. It acts as a safety net, providing assurance to the lender and the beneficiary that payments will be covered in case of default.
• Commercial Letter: Ideal for regular shipments of goods, bulk trades, and large product orders where timely payment is crucial. This type of letter can also function as a revolving letter, allowing for multiple transactions under the same contractual terms, which is beneficial for ongoing supply agreements.

In international trade, the choice between these two types depends on the nature of the deal and the specific requirements of the parties involved. A standby letter offers peace of mind for ongoing agreements and long-term projects, ensuring that obligations will be met even if the buyer defaults. A commercial letter ensures timely payment for specific shipments, providing confidence to exporters and facilitating smoother global transactions.

Choosing the Right Letter for Your Business

Consider your business model, transaction type, and risk tolerance. If you need a payment guarantee as part of your contractual agreement, a commercial letter of credit is ideal. It ensures that payment will be made once the specified conditions are met, providing security for both the buyer and seller. A standby letter of credit offers added security against non-payment by ensuring the issuing bank will cover the payment if the buyer defaults.

Businesses in high-risk markets or international transactions often prefer confirmed letters of credit for added security, as they include a guarantee from a confirming bank. This is especially important for large sums or unfamiliar partners. Companies with complex supply chains may also benefit from transferable letters of credit, allowing them to transfer payment rights and increase flexibility.

Pros and Cons of Standby Letters and Confirmed Letters of Credit

Understanding these pros and cons helps businesses make informed decisions. It’s important to weigh the costs against the level of security provided.

• Standby Letter Pros: Provides assurance without affecting cash flow, making it an excellent backup payment mechanism. It helps businesses maintain liquidity while still offering security in case the buyer fails to fulfill their obligations.
• Standby Letter Cons: Limited use for direct payment since it is only triggered in the event of default. This makes it less suitable for businesses that require immediate payment upon fulfilling their part of the deal.
• Confirmed Letter Pros: Double security reduces risks significantly, especially in international trade. The involvement of both the issuing and confirming banks provides added confidence to the seller, ensuring that payment will be made regardless of the buyer's financial situation.
• Confirmed Letter Cons: Higher fees due to the secondary guarantee provided by the confirming bank. These additional costs can impact the overall profitability of the transaction, especially for smaller businesses or lower-margin deals.

Considering the parties involved, including the applicant, beneficiary, issuing bank, and confirming bank, can also influence the choice between standby letters and confirmed letters of credit. By carefully evaluating your business needs and the specific details of each transaction, you can select the most suitable financial instrument to support your growth and reduce payment risks.

International Trade Laws and Regulations Common Among Countries

Global trade relies on standardized regulations to ensure smooth, fair, and legally compliant transactions. Various international laws and guidelines help businesses navigate complex financial agreements, mitigate risks, and promote transparency. Here are some of the most widely recognized trade regulations:

• Uniform Customs and Practice for Documentary Credits (UCP 600): UCP 600, issued by the ICC, standardizes rules for documentary letters of credit (LC). It defines the responsibilities of banks and beneficiaries, regulates payment conditions, and ensures consistency in global trade. While mainly for commercial LCs, its principles also influence SBLCs when documentary conditions apply.
• International Standby Practices (ISP98): ISP98, also from the ICC, governs standby letters of credit (SBLC). It sets clear rules for issuing, presenting, and honoring SBLCs, ensuring structured payments in case of default. It defines obligations for banks and standardizes SBLC processes, complementing UCP 600 in trade finance.
• Incoterms: Incoterms, created by the ICC, define buyer and seller responsibilities in trade. They determine risk transfer points, influencing LC payment terms. By clarifying contract obligations, Incoterms help structure LCs and SBLCs to align with global trade laws like the CISG.

By adhering to these standardized trade laws and regulations, businesses can operate with greater confidence, minimize legal risks, and foster trust in international markets.

FAQs About Standby Letters of Credit and Letters of Credit

1. What is the main difference between a standby letter of credit and a letter of credit?

A standby letter is a backup payment guarantee, providing security in case of default, while a letter of credit is the primary payment method used for direct transactions.

2. When should I choose a confirmed letter of credit?

When dealing with high-risk countries, unstable markets, or unfamiliar buyers where payment security is a top priority.

3. Are standby letters of credit used for goods transactions?

Rarely. They’re mostly for services, long-term contracts, and performance guarantees rather than regular goods transactions.

4. Do letters of credit require collateral?

Often, yes. Banks may ask for collateral depending on the applicant's creditworthiness and the size of the transaction involved.

5. Can fees differ between standby and confirmed letters of credit?

Yes. Confirmed letters usually have higher fees due to added bank involvement and the secondary guarantee provided.

Making the Right Financial Choice Between Standby Letter of  Credit vs Letter of Credit

Choosing the right financial instruments is crucial for securing transactions and minimizing risks when operating internationally. Understanding the differences between a standby letter of credit and a letter of credit, along with their specific use cases, is essential for effectively navigating global trade. By selecting the appropriate financial instrument, you can ensure payment security, build trust with international partners, and streamline your operations.

With extensive experience in international transactions, Suisse Bank offers tailored financial instruments, including letters of credit and standby letters of credit, to meet your business needs. Our secure payment options and global expertise can help you mitigate risks and optimize your international trade operations.

Join us today to explore how we can support your business in achieving global success.