A letter of Credit is a documentary credit that an issuing bank guarantees to the suppliers if the buyers default on payment. Banks become intermediary parties between the sellers and buyers, usually in international trade contracts. However, the documentary credit or LC contracts are different documents from the original sales contract. Depending on LC characteristics, it can be of different types and performing nature.
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What is a Revocable Letter of Credit?
A Revocable letter of credit is a documentary credit that can be amended or canceled without prior notice to the receiver (sellers). As the revocable letter of credit can be amended, canceled, or revoked at any time and it cannot be confirmed.
Any letter of credit is by default irrevocable in contract terms. If the issuing bank or the buyers require a revocable letter of credit, it has to be clearly mentioned in the LC contract explicitly. A Revocable letter of credits an uncommon form of LCs used in international trade. The prime purpose of an LC is to offer assurance to the second party.
The revocability clause of the LC remains effective until the documents are not presented for clearing with the advisory bank. Once the supplier (second party) presents the documents and meets the sales contract terms, the revocability clause does not come into effect.
How Revocable Letter of Credit Works?
Global trades usually involve the irrevocable letter of credits. If a buyer issues an irrevocable LC, it has to be incorporated in the contract. Both parties must be made aware of the revocability terms of the LC contract. By contract and working nature, the revocable LC works similarly to any other type. The only difference arises due to its limited functionality and utilization.
A typical revocable (and irrevocable) letter of credit works in flow like:
- Both parties in trade agree on the sales terms and payment through an LC
- The buyer approaches the issuing bank to issue an LC against the payment
- LC is issued to the advising bank in the seller’s country (bank or a clearing house)
- The seller sends the goods supplies to the buyer
- Sellers presents LC documents and clears the payment through advising payment after the goods reach the buyer’s destination
- The buyer than approaches the issuing bank to clear the payments and documents to receive the goods from the Shipping forwarders or customs
The general mechanism of an LC works in a similar way for any type of LC. However, the revocable LC is different in the sense that it allows for any amendments. For example, during the process stated above, the buyer may approach the issuing bank to revoke or amend the LC before the final payment is released. If the LC issued was irrevocable, it couldn’t be amended for any sort of amount or clause changes. Due to this insecure nature from the seller’s point of view, the sellers usually avoid the revocable LC contracts.
Why Buyers Issue a Revocable Letter of Credit?
In the modern business market, the use of revocable LC is very limited. However, some buyers making trade deals with unknown suppliers in the overseas market may not be willing to take the full risk. Suppliers in far-flung countries who require long shipment times do not find favorable trade deals. The issuing banks may also influence the decision if the buyers do not have an adequate level of credit available.
Some common reasons why a revocable Letter of Credit is issued:
- The trade deal between the parties does not contain strict payment terms
- One of the trade parties reside in an unstable economic or political geography
- The Issuing Bank may not guarantee the credit
- The buyers (LC applicants) lack the trade trust in the supplier and want to keep the options safe till the goods are shipped
- Buyers feel the product prices may change due to market fluctuations
Types of Revocable Letter of Credit
By credit type and payment terms, the revocable LC can take different forms. A letter of credit can be backed by collateral or an unsecured form. It can be transferable, revolving, confirmed, or unconfirmed in nature. A revocable LC is always unconfirmed by definition.
Revocable and Transferable: the issued LC is revocable in nature and can be transferred to the other beneficiaries. The credit transfer becomes highly unlikely as the revocability clause limits its functionality.
Revocable and Standby: the LC is revocable and comes with standby features. A standby LC mitigates the losses due to unfavorable circumstances to the suppliers.
Revocable Secured LC: the issued LC is secured by collateral from the buyer.
Revocable Un-secured LC: the issued LC does not come with any collateral cover from the buyer. Issuing banks consider the buyer’s creditworthiness as the sole collateral.
Advantages
As the revocable letter of credit is an unconfirmed credit, it serves benefits exceedingly to the buyer (the first party). It is a unique LC contract in the sense that an advantage for one party becomes a limitation for the second party. Banks acting as the third party may also reduce the liability with a revocable LC.
- The first party (buyers) can amend or revoke the LC at any time without notifying the second party (sellers)
- Buyers can approach and secure favorable trade deals with revocable LC with suppliers lacking sales in international trade
- The suppliers’ only motivation with a revocable LC remains the first time access to the international market
- Suppliers may insist on revocable and Transferable or secured (by collateral) LC to mitigate the default risk
- The Issuing banks do not hold obligations to serve the Revocable LC contracts if the terms are not met
Disadvantages
International Trade relies upon letters of credit and guarantees issued through banks and clearing houses. Suppliers feel an extra layer of security with an LC in case of buyer defaults. The bank becomes intermediary and guarantors to proceed with the payments in case of an unlikely event. The Revocable LC negates these primary functionalities and characteristics of the LC in international Trade. Although it offers flexible terms to the first party, the second party (suppliers) find themselves at big disadvantages with a revocable LC.
- Comes with a risk of default or revocability at any time before the contract completion
- Suppliers usually cannot transfer the revocable LC credit (due to lack of acceptance in the market)
- Suppliers may face a risk of economic loss due to forced terms by the buyers
Conclusion
Revocable LCs are issued in rarity in modern international trade. Buyers with a lack of funds or collateral may issue a revocable LC. A revocable LC can be amended or revoked at any time without notifying the second party. The revocability clause makes it an unfavorable and risky contract for the suppliers.
