In the current era, when trade and commerce have no borders, and people buy and sell their goods and services around the world, the issue of how they can secure the payments from the buyers, which they don’t even know, that’s when the letter of credit comes into place. The instrument serves as a guarantee between the parties that the payments will be made if the buyer default on their payments. There are various types of letters of credit, such as revocable, irrevocable, standby, deferred, confirmed, and unconfirmed LC, etc.
For more information about Letter of Credits, you can read:
Everything You Should Know About Letter of Credit
What is a revocable letter of credit and its example?
A revocable letter of credit is a financial instrument that can be amended or canceled by the issuing bank without the approval and consent of the beneficiary or trading parties. This LC does not provide any security, and it could be terminated anytime and financial loss can be expected by the seller.
On the other hand, the buyer is not in a safe position either as the seller can also amend the requirements of the LC and makes things in their favor like extending the deadline of sending the shipment.
These instruments can be amended at any time between when the seller ships the products, sends the relevant document to the issuing bank(the issuing bank may also ask the seller for additional documents not initially requested and can also change the expiry date of the LC and despite that, the bank may still refuse to act as a mediator).
Issuing this LC indicates that the bank is not ready to bear the risk or guarantee the payment associated with the contract, along with it showing the weak financial strength of the bank to make the payments.
A Russian firm name ABC limited(buyer) has a contract with a USA firm(seller) for 3 pieces of machinery like bulldozers and scrapers. Being an international shipment, the seller asked for a letter of credit to secure the payment, and the buyer asked his bank(issuing bank) to issue a revocable letter of credit and sent it to the seller.
The seller successfully shipped the pieces of machinery and when he asked for his payment from the issuing bank, they refused the payment, on the other hand when he contacted the buyer, he said he don’t have the money to pay and he was dependent on LC and made seller vulnerable to fraud.
After further inquiring, the seller discovered that revocable LC gives the bank the option to refuse the payment and now he has to recover the payment directly from the buyer.
Types of Revocable Letter of Credit
There are two types of revocable letter of credit, secured and unsecured.
For a secured revocable letter of credit, the buyer has to give a personal guarantee or mortgage security. For an unsecured revocable letter of credit, the bank just checks the creditworthiness of the buyer. Please note in both cases, the bank can revoke the LC.
Difference between a revocable and irrevocable letter of credit?
Revocable and irrevocable letter of credit mainly differentiates in 3 ways from each other.
The first one is, of course, revocability while the former can be revoked at any stage of the LC and is an unapproved instrument, the latter cannot be revoked and is a definite undertaking by the issuing bank to pay the seller.
The second one is how much secure this payment method is, revocable LC is a much risker option for all the parties involved as it doesn’t guarantee any payment to the beneficiary on the other the latter confirms that the issuing bank will honor the payment and third and last one is about the usage, revocable LC is the least use instrument reason being how powerless this leaves both the parties while irrevocable LC is used frequently.
It should be noted that both LC works the same way, however, limited functionality and utilization persist with revocable LC.
Under what circumstances a bank may revoke the revocable letter of credit?
As a ground rule, this type of revocable letter of credit can be revoked at any time by the bank, however, still, there are following circumstances where the bank has to revoke the LC:
- Political tension
- Deteriorating market conditions
- Financial crisis
Why Buyers Issue A Revocable Letter Of Credit?
While it’s never advised to issue this LC, people usually use it in cases where the contract that parties have entered into doesn’t have proper conditions and terms attached to it or if either party lives in an environment of political tensions or economic crisis in this situation the bank can’t guarantee payments or the buyer doesn’t have a good credit history and even doesn’t have a guarantee or collateral to give as a security to the bank.
In addition, this LC is issued when parties feel that the price of the goods or services may increase before the contract is fulfilled. It is also issued when the buyer is doubtful about the seller’s trustworthiness and wants to have an option if he observes signs of fraud.
When does a revocable letter of credit become irrevocable?
As you have learned above the bank has the power to revoke this LC, however, there’s a threshold above which the bank loses this authority. Once the seller has shipped the goods and services and produced those documents to the advising bank, once the documents are accepted by the bank, it becomes irrevocable.
Advantages and disadvantages of revocable letter of credit
It has no significant advantages, except for the fact that it puts the buyer on a safer side, however, this also means that this becomes a risk for the seller, and if the buyer would like, he could refuse to pay through this LC.
The second benefit is that it is affordable. The banking fees associated with this transaction are considerably lower than any other. Another type of LC and for that reason, it is used in between sister-concern or subsidiary companies.
Disadvantages: Revocable LC has a number of negative aspects, it negates its prime responsibility of providing security and acting as an intermediary, and for these reasons, it has been removed from the UCP600 which is the common code for harmonizing LC published by the ICC. Some of the disadvantages are listed below:
- Can be revoked anytime
- Both the parties are at a disadvantage position and financial loss is expected
- Non-transferable instrument due to lack of authority/security related to issuing bank
- An unapproved document that adds to the security risk.
Which type of letter of credit cannot be canceled by the bank?
The question surely occurs to you that if this is an untrustworthy LC, then what should be used to ensure the parties are paid the answer is the revocable letter of credit, this instrument cannot be canceled or changed except in the condition explicitly mentioned in the contract.
Revocable letter of credit are rarely used for international as well as domestic transactions and the reason remains the same, lack of security defeats the purpose of using a letter of credit, and neither it is issued by banks as they refrain from getting into problems after issuance of LC.