Standby Letter of Credit: New Amazing Introduction
Imagine a situation where you have ordered a bunch of goods from Alaska, you have a contract with an international seller, who initially resisted doing business with you because he didn’t know you and was worried about getting scammed, but you gave them a standby letter of credit, and now he is happy and relieved.
But how? Let’s understand.
What is a Standby Letter of Credit (SBLC)?
As defined in Investopedia, a standby letter of credit (SLOC) is a legal document that guarantees a bank’s commitment of payment to a seller in the event that the buyer–or the bank’s client–defaults on the agreement.
This is used to hedge the risk where the seller and buyer don’t know each other. This SBLC assures the seller that your payment will be made irrespective of the circumstances.
It also shows the buyer’s ability to make payments for the services and goods and increases their trust within the seller.
This instrument is irrevocable and hence can’t be changed or canceled without the permission of both parties.
How to get a standby letter of credit?
To obtain an SBLC, the Buyer requests for SLBC from the bank, followed by which bank assesses the creditworthiness of the buyer and performs due diligence, and if it doesn’t seem to meet the standards, then the bank may ask the buyer for the collaterals in the form of fund or asset based on the level of risk.
As part of the process, the buyer must also provide the bank with information such as shipping documents, beneficiary’s bank, seller name, the period for which the SBLC is valid.
Once the background checks are done and verified, the SBLC is issued to the buyer, who is then given to the seller, and in the event of non-payment, the seller can present the SBLC to the buyer’s bank and get his payment.
How do SBLC works?
Once the buyer and seller get into a contract, the buyer request the SBLC from a bank(called as issuing bank) which then intimates the advising bank(called as seller’s bank) about an SLBC being issued, which further communicates it to the seller. Post that, the contract is executed.
In case the payment is not made by the buyer, then the issuing bank process the payment to the seller after submitting the copy of the bill of lading, unpaid invoices, written statement of non-receiving of payment.
What is the cost of SBLC?
SLBC cost varies from 1-10% of the entire amount of issued SBLC. It is charged yearly to the time the SBLC is charged and is also subject to extension. However, if the payment has been made before the time that it can be canceled without any additional charges.
Types of SBLC
This SLBC is used as a guarantee for payment incurred due to the seller’s goods and services as per the contract;
For example: If a seller has shipped to you from a foreign country and the buyer defaults on the payment, then the seller can present the financial SBLC to the buyer’s bank and can collect payment.
This SBLC is useful when the service provider fails to complete his work or any non-financial contractual obligation.
This will act as a guarantee for the completion of the project and can also provide you with compensation depending on the circumstances.
For example, if you have hired a software engineer to install a new application in all your company’s systems, and the engineer fails to do the same in a given time frame, then performance SBLC will provide you the fees and ensure the completion of the project.
Advance Payment SBLC
This legal document act as a guarantee for a client who makes advance payments that his project will be completed as per the contractual terms.
Bid bond/ Tender SBLC
This legal document acts as a security in case of the party defaults on completion of the project after he has been awarded the tender to the bid for it.
This SBLC is, commonly known as backstop or protective SBLOC, is issued by letter of the credit provider from one country to another to request them to issue a local undertaking to the beneficiary and supported by a separate SBLC.
SBLC is typically issued in international transactions, and since SBLC issued in another country holds less value than if they are issued in the beneficiary’s country.
Direct Pay SBLC
In this SBLC, the issuer honors the draft by paying the beneficiary as soon as the requirements of the documents are met. The payment might or might not be related to performance or the financial default.
Advantages and disadvantages of SBLC
SBLC provides clients with easy and convenient access to financial coverage, both internationally and nationwide.
Due to the wide variety of SBLC, this covers default risk for both services and goods, which facilitates international trade by assuring guaranteed payments and bridges the gap that exists between two countries (buyer and seller) due to different laws and regulations.
Standby Letter of Credits only protects the seller!
A Standby Letter of Credit vs. Bank Guarantee
SLBC and bank guarantee hold differences and similarities related to nature, usage, protection, practicality, risk coverage, the legal aspect.
|Aspect||Standard letter of credit||Bank guarantee|
|Time period||It has a limited scope since it is only used for long-term contracts.||It has a broader scope since it is used both for long-term as well as short-term contracts.|
|Usage||This is commonly used for international transactions||This is used for both domestic and international transactions.|
|Protection||This provides protection against the sellers only.||This provides protection to both parties.|
|Risk||This can be used to hedge out the risk for financial and non-financial factors.||This is used where the financial factor is involved.|
|Laws||SBLC has to adhere to banking protocols.||BG is subject to civil law.|
|Bank involvement||Commonly, more than one bank is involved in SBLC, and it is usually a foreign bank.||Only one bank is involved|
Standby Letter of Credit Examples
Sonya, a Miami-based homeowner, wants to purchase 1000 Bohemian bags from Mark, an Indian resident, but Mark wants assurance that Sonya will make the timely payments. Obliging to this request, Sonya issued a SBLC.
If Sonya fails to make payments, the mark can get his payment from the bank that issued the SBLC.
What is a Letter of credit?
LC, also known as a payment guarantee letter and credit letter, is a standard payment document that guarantees a seller that payment will be made and a buyer that all contractual obligations will be met.
The seller can get the payment for its order by submitting documentary evidence of delivered goods, which is verified by the bank and payment is made, whereas SBLC is a secondary payment method used when there’s a contingency related to the performance of a contractual obligation and the bank makes the payment if a default has occurred.
LC charges range from 0.75% to 1.50%, depending on the amount involved. Letter of credit is issued for a short-term, and this expires in 90 days, while SBLC is commonly issued for more than a year.
How do you monetize a standby letter of credit?
Monetization means the process of raising money out of legal instruments like SBLC, which are drafted to raise cash. Let’s understand this problem with an example,
You need $1000 urgently, you request your bank to issue an SBLC(a bank instrument) of $1200, you transfer the SBLC through swift or other trending platforms (called as monetizer) and ask for cash against it.
To monetize, after performing the due diligence and verifying the instrument, issues 70-80% of the face value of that instrument to you instantly or within a few weeks.
After one year, the monetizer will submit this legal instrument to the issuing bank and demand the $1200 from the bank, and this is how the monetizer makes a profit between the transaction, and you get your money when you need it.
This means that you take advance payment against your financial instrument, which will be taken back from you after some time, probably one year. Before transferring it to monetization, you must take care of the following things:
- SBLC needs to be issued by top-rated AAA banks, and SBLC issued by unrated banks are rejected or require a corresponding bank
- The face value of the financial instrument should not exceed five million dollars, and it must be valid for at least 11 months before expiration.
A standby letter of credit relieves the worries of new businesses that cannot have overseas clients who are afraid of losing money and are unable to compete with bigger and well-known competitors. SBLCs allow people to transact stress-free and to have overseas clients even when large amounts of money are involved.