Standby Letter of Credit (SBLC)
It enables buyers to ship goods immediately after a contract has been signed and the buyer has received confirmation from the bank.
What is a Standby Letter of Credit (SBLC)?
A letter of credit is a document issued by a bank promising that a buyer will pay a seller on time and completely.
Why do we need a letter of credit? In international trade transactions, when the buyer and seller might not be acquainted, letters of credit are used to reduce risk.
If you are an importer, it will help you ensure that your business will only make payments for purchases once the supplier has presented proof and documentation that the products have been transported.
A standby letter of credit is a type of letter of credit that enables buyers to ship goods immediately after a contract has been signed and the buyer has received confirmation from the bank.
The standby letter of credit is also commonly used as a pre-shipment finance instrument. In this method, sellers (exporters) can ask their buyers (importers, banks, or commission agents) to provide a guaranteed advance before shipment.
If buyers do not trust the seller or do not want to lose money due to disputes during the shipment of goods, they can use a standby letter of credit before the conclusion of the sales contract. The seller uses a bank as an intermediary to secure the buyer’s payment.
Key Takeaways
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Standby letters of credit are expensive.
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They can only be used in relatively simple transactions; they are most advantageous for trade between large companies and companies that can quickly make large sums of payments.
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They can be used for payments with a high value but are likely to be paid in a few years.
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If there is no buyer's acceptance or irrevocable letter of credit, it may be difficult for the beneficiary company to respond to the buyer’s requests.
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If the letter of credit does not have an expiration date, it will likely expire before its expiration date, even if both parties want it to continue.
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Disputes can arise between the seller and buyer if the contract terms are unclear.
Standby Letter of Credit (SBLC) requirements
The requirements that must be met for Standby Letters of Credit include the following:
1. Guaranteed payments
The seller must have an agreement with the bank, guaranteeing payment for any product delivered per agreed specifications.
2. Beneficiary
The seller should be the beneficiary who will obtain the goods specified in the contract.
3. Bank's consent and the buyer's signature
The seller should have received confirmation from his bank that the bank has accepted his letter of credit and that payments will be guaranteed. At this stage, the seller can deliver his goods as per the agreed specifications and wait for the payment.
4. Delivery of documents (sometimes called documentary evidence, which are receipts or invoices given to a bank by a buyer or seller)
For a Standby letter of credit to be issued, both sides should have produced original contracts and proof of ownership as per agreed specifications.
5. Terms and conditions of the letter of credit
The terms and conditions of the letter of credit should be in writing, but the buyer can also rely on other documents.
6. Reference number
The bank provides a number to indicate that all requirements have been met, and the buyer can apply for payment.
7. Terms, Time, and Place
The seller should inform the bank which dates and how long he wants his goods to be held if he is required to wait for payment. He will also be informed where he needs to pick up his goods, either in his country or at a specific global location such as Dubai airport or the USA.
Standby Letter of Credit Vs. letter of credit
The duration of a standby letter of credit refers to how long it takes for you and your bank.
The answer is that it depends on both parties, but generally speaking, letters of credit last for one year unless both parties agree to renew them. Of course, different loopholes apply depending on the circumstances. For example, letters of credit have a validity period of one month.
If you, as both party and beneficiary, want to extend the duration period, you should petition your issuing bank for an extension in writing. Most banks would gladly renew it for another year.
As for the issuing bank, naturally, they would want to protect their interests. But in addition, they would be considering their risk of non-performance. So, they might ask you to terminate the letter of credit earlier than the original date.
Note that issuing banks are under no obligation to extend or renew letters of credit. In such cases, it is your responsibility as both parties to negotiate and agree on the issue date or exact time for renewal.
While a Standby documentary credit letter is a long-term instrument with a validity of one year, a letter of credit is a short-term instrument with a typical expiration date of 90 days.
Area of Use/Cost of Issuance: In a sale agreement, a letter of credit is the trade finance instrument that is mostly utilized, but an SBLC is typically used to offer security in extensive construction projects. Furthermore, SBLCs are utilized in domestic transactions.
According to eFinance Management, Standby LC costs more to issue than a standard LC.
The costs to issue a regular SBLC range from 1% to 10% of the covered amount, while the costs to issue an LC range from 0.75% to 1.50%. Therefore, it is estimated that an SBLC issuance transaction costs $500 on average.
In SBLC-based transactions, the provider of the SBLC is acting as an underwriter and assumes more credit risk, therefore charging a higher price for its services.
The SBLCs are usually transacted in the interbank market (either directly between banks or through an arranger) but sometimes can be purchased from a finance house (in which case it is known as a bank-accepted bill).
In the United States, Standby Letters of Credit are denominated in dollars. They are classified as "standby" – i.e., standby letters of credit – when only the issuing bank can call for payment due to an adverse change in circumstances (adverse change).
In other countries, such as Japan, an SBLOC is issued by a specified bank and called upon to make payments on behalf of another bank or company.
Advantages of a Stand by Letter of Credit
The main advantage is that it can be negotiated more easily than a standard loan or letter of credit. In addition to this convenience, there are also many other benefits, such as expedited processing time and increased security/liquidity.
The disadvantages revolve around the cost of issuing an SBLC and the risks associated with using these documents. These issues can make your company’s decision-making process more cumbersome and require additional planning on your behalf.
The SBLC is issued by a bank and drawn in favor of the holder, usually an overseas market participant. The SBLC is prepaid by the lender and must be used within a year for the entire value.
The lender bears all the risks associated with its use, whether this means loss of value or repossession of collateral. In addition, lenders are not allowed to require multiple uses.
This means once a bank has issued an SBLC, it cannot disburse that amount elsewhere unless it spends more money on new processing fees or additional facilities (for example, engraving).
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It can save time and money due to lower processing costs for the issuer.
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It can help streamline business dealings.
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In an emergency or crisis, a standby letter of credit can be very useful in explaining the situation and obtaining necessary funds.
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It can provide more security to the customer.
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Standby letters of credit are often used to finance transactions that would not require a lump-sum payment, such as arms sales and machinery purchases.
Disadvantages of a Stand by Letter of Credit
A standby letter of credit requires full knowledge and authorization from both the buyer and seller (a buyer's acceptance is needed if a company is issuing it). It may be difficult for both sides to agree on terms when this is impossible.
Before buying or making a purchase, it is important to understand the risks involved in that transaction.
One of these risks is the Standby Letter of Credit, which means that if you need to make a payment and don’t have enough money, you can use this document to guarantee your payment.
The problem with this document is that there are significant disadvantages associated with it, such as:
1. Low Liquidity
Since Standby Letters of Credit are meant to be used only when the buyer cannot or does not have enough money, the seller cannot count on this available payment.
Because of this, it is extremely difficult to sell a Standby Letter of Credit at any time because nobody wants to purchase a document they may never be able to use.
2. Low Credit Rating
Since Standby Letters of Credit are rarely used, most banks, lenders, and other financial institutions don't consider it high-priority credit.
This means that the sellers of these documents will have a low credit rating, so you can expect higher interest rates for your purchases.
3. Higher Interest Rates
Because of the low credit rating associated with Standby Letters of Credit, they will cost you a lot of money if and when you do try to purchase those documents.
This is why buying these documents from banks, lenders, and other financial institutions with a decent credit history is important.
4. Possible Default
Although Standby Letters of Credit could theoretically be a good thing, they have been known to default if not used properly. Because of this, the person buying this document must fully understand how it works to ensure it can be used properly.
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