The Standby letter of credit is suitable when an Exporter have an established relationship, characterised by a regular volume of trade, with an Importer. In this case, there is a clear need for flexibility as many orders are likely to be amended during any given fiscal year. From this perspective, using a classic letter of credit can be burdensome, time consuming and costly since each amendments requires the approval of the applicant and the issuing bank which will charge amendment fees accordingly.
Needless to say that, Sellers who trade on an open account basis with their regular clients, still need to cover the risk of non-payment.
This is where the letter of credit Standby represents the best solution, as the amount of documentation is particularly limited and the risk of non-payment for the exporter inexistent.
The Standby letter of credit is based on two main sets of rules, the Uniform customs and practice for documentary credit (UCP 600) developed by the International Chamber of commerce as well as, the International Standby practice (ISP98) developed by the Institute of International Banking Law and practice.
The figure below depicts the Standby letter of credit process.
After a while, the Seller decides to trade with an Importer on an open account basis providing that a Standby letter of credit is issued.
The buyer asks his bank to issue a Standby letter of credit
The issuing bank informs the advising bank (seller’s bank) that a Standby letter of credit has been issued.
The advising bank or local bank informs the Exporter that he is the beneficiary of a Standby letter of credit.
If the buyer has some concerns about the reliability of the issuing bank (exotic country), he can ask the advising bank to confirm the Standby letter of credit and become the confirming bank.
By doing so, the confirming takes on the obligation to honour the payment instead of the issuing bank.
Step 5 A:
The Exporter organise the shipment of the goods based on what has been agreed with the buyer.
In turn, the buyer pays following the terms of the sales contract (at sight, deferred payment, time draft, etc.). Since the payment has been made in compliance with the agreement, the seller will not use the Standby letter of credit.
Step 5 B:
Unfortunately, the buyer did not honour his engagement to pay despite several reminders. In this case, the Exporter provides the documents requested in the letter of credit Standby which prove that the goods have been delivered and the payment has not been made.
The bank (issuing bank of confirming bank) processes the payment to the buyer since he is the beneficiary of the letter of credit Standby.
The Issuing bank debits the buyer’s account.
As you can see, the Standby letter of credit process is less formalistic than the classic letter of credit. Indeed, sometimes the seller might be asked to provide a single document. However usually, the documentation requirement can include:
– Copy of unpaid invoices
– Copy of Bill of lading
– A written statement signed by the Exporter, which indicates that he did not receive the payment
In addition, the Standby letter of credit is usually less costly than the classic letter of credit. Moreover, it represents a more flexible tool for the buyer who can request to amend several orders, as this does not impact the standby letter of credit.
It worthwhile noticing that given that with a Standby letter of credit, the risk of non-payment is inexistent, there is no need to purchase an Export credit insurance.