What Is a Transferable Letter of Credit?
A transferable letter of credit is a type of letter of credit that permits the first beneficiary to transfer some or all of the credit to another party, thus creating a secondary beneficiary. The first beneficiary is typically the party accepting the transferable letter of credit from the bank, whereas the applicant is the one who initially applies for this letter. This mechanism is widely used in business transactions to secure payment to a supplier or manufacturer, serving as an alternative to advance payment.
Key Takeaways
- Enables initial beneficiary to transfer some or all of the credit to another party.
- Utilized in business deals for securing payment to suppliers or manufacturers.
- Involves parties such as the applicant (buyer), first beneficiary (e.g., retailer), and second beneficiary (e.g., supplier).
How Transferable Letters of Credit Work
A letter of credit is essentially a bank’s promise that a seller will receive the payment for goods or services provided. If the buyer defaults, the bank covers the payment. This is especially critical in transactions between importers and exporters, where reliable credit information is hard to come by.
For instance, manufacturers often require a letter of credit to ensure payment before proceeding with an order. The buyer applies for one and pays a fee for this guarantee
A transferable letter of credit allows this assurance to be passed on to another party, the secondary beneficiary, such as a supplier the primary beneficiary depends on. Thus, creating a secure chain of transactions from the buyer to the final supplier. Multiple secondary beneficiaries can also participate in such an arrangement.
Obtaining a Transferable Letter of Credit
These letters are available from many international banks. The approval process resembles applying for a bank loan. The buyer must complete a credit application detailing income, assets, existing debts, and specifics of the transaction. Banks then assess the creditworthiness of the borrower and decide on the credit terms and approval.
Despite not being an actual loan, this letter guarantees the bank’s support in payment if necessary.
Transferable Letter of Credit vs. Confirmed Letter of Credit
A transferable letter of credit is simpler as it involves one banking institution. On the other hand, a confirmed letter of credit necessitates two banks. A second bank, familiar to the seller, backs up the first letter of credit. This ensures payment security even if the initial bank defaults. Such confirmed letters are common in international trade involving parties from different countries.
What Is a Commercial Letter of Credit?
A commercial letter of credit is one where the bank releases funds directly to the beneficiary (usually the seller) upon fulfilling obligations. This contrasts with standby letters of credit, where the bank steps in to pay only if the buyer fails to make the payment.
What Is a Back-to-Back Letter of Credit?
A back-to-back letter of credit involves two separate letters for the same transaction, generally with a middleman like a broker. The buyer issues a letter of credit to the middleman, who in turn issues another to the supplier. This tiered arrangement ensures all parties receive payments.
What Is a Revolving Letter of Credit?
A revolving letter of credit extends over multiple transactions, beneficial for ongoing buyer-supplier relationships. It negates the need for negotiating a new letter each time, thus streamlining repetitive international transactions.
What Is a Credit Facility?
A credit facility is a loan agreement allowing access to funds as needed rather than a lump sum upfront. Revolving credit acts as one such facility, providing flexibility in funds’ management.
What Does a Letter of Credit Cost?
Banks typically charge a percentage fee based on the guaranteed amount, varying by creditworthiness and covering from about 0.75% to 2%.
The Bottom Line
Letters of credit are crucial tools in business transactions, especially across international borders or new business relationships. Transferable letters of credit secure payment chains from buyers to their suppliers, ensuring goods and services flow smoothly. Although they entail costs, they can facilitate complex deals that cement robust business relationships.
Related Terms: Letter of Credit, Confirmed Letter of Credit, Commercial Letter of Credit, Standby Letter of Credit, Back-to-Back Letter of Credit, Revolving Letter of Credit, Credit Facility.
References
- Export-Import Bank of the United States. “How Does a Letter of Credit Work and What Is It?”
- U.S. Department of Commerce International Trade Administration. “Trade Finance Guide: A Quick Reference for U.S. Exporters”, Page 4.
- U.S. Department of Commerce International Trade Administration. “Trade Finance Guide: A Quick Reference for U.S. Exporters”, Page 8.
- Cornell Law School Legal Information Institute. “Credit Facility”.
