Payments Academy
Standby letter of credit PAYMENT OPERATIONS STARTED LIVE 01 Standby letter of credit - written undertaking by a bank to pay ACTIVE 02 Beneficiary - If the applicant defaults QUEUED 03 Contractor abandons - If the contractor abandons the site QUEUED 04 Separation - gives the beneficiary certainty QUEUED 05 Expiry date - available balance therefore matter on every QUEUED 06 Applicant - have a credit facility or collateral QUEUED A standby letter of credit is a written undertaking by a bank to pay a stated amount to a named beneficiary if the applicant fails to perform a stated obligation. Step 1 of 6 Standby letter of credit STARTED Standby letter of credit written undertaking by a bank to pay ACTIVE Beneficiary If the applicant defaults QUEUED Contractor abandons If the contractor abandons the site QUEUED Separation gives the beneficiary certainty QUEUED Expiry date available balance therefore matter on every QUEUED Applicant have a credit facility or collateral QUEUED A standby letter of credit is a written undertaking by a bank to pay a stated amount to a named beneficiary if the applicant fails to perform a stated obligation.
Beneficiary can present PAYMENT OPERATIONS IN PROGRESS LIVE 01 Standby letter of credit - written undertaking by a bank to pay DONE 02 Beneficiary - If the applicant defaults ACTIVE 03 Contractor abandons - If the contractor abandons the site QUEUED 04 Separation - gives the beneficiary certainty QUEUED 05 Expiry date - available balance therefore matter on every QUEUED 06 Applicant - have a credit facility or collateral QUEUED If the applicant defaults, the beneficiary can present a demand and the required documents, and the bank must pay. Step 2 of 6 Beneficiary can present IN PROGRESS Standby letter of credit written undertaking by a bank to pay DONE Beneficiary If the applicant defaults ACTIVE Contractor abandons If the contractor abandons the site QUEUED Separation gives the beneficiary certainty QUEUED Expiry date available balance therefore matter on every QUEUED Applicant have a credit facility or collateral QUEUED If the applicant defaults, the beneficiary can present a demand and the required documents, and the bank must pay.
Contractor abandons PAYMENT OPERATIONS IN PROGRESS LIVE 01 Standby letter of credit - written undertaking by a bank to pay DONE 02 Beneficiary - If the applicant defaults DONE 03 Contractor abandons - If the contractor abandons the site ACTIVE 04 Separation - gives the beneficiary certainty QUEUED 05 Expiry date - available balance therefore matter on every QUEUED 06 Applicant - have a credit facility or collateral QUEUED If the contractor abandons the site, the project owner presents a demand, and the bank pays up to the stated limit. Step 3 of 6 Contractor abandons IN PROGRESS Standby letter of credit written undertaking by a bank to pay DONE Beneficiary If the applicant defaults DONE Contractor abandons If the contractor abandons the site ACTIVE Separation gives the beneficiary certainty QUEUED Expiry date available balance therefore matter on every QUEUED Applicant have a credit facility or collateral QUEUED If the contractor abandons the site, the project owner presents a demand, and the bank pays up to the stated limit.
Separation: at fault in underlying PAYMENT OPERATIONS IN PROGRESS LIVE 01 Standby letter of credit - written undertaking by a bank to pay DONE 02 Beneficiary - If the applicant defaults DONE 03 Contractor abandons - If the contractor abandons the site DONE 04 Separation - gives the beneficiary certainty ACTIVE 05 Expiry date - available balance therefore matter on every QUEUED 06 Applicant - have a credit facility or collateral QUEUED This separation gives the beneficiary certainty, because payment does not depend on a court deciding who was at fault in the underlying deal. Step 4 of 6 Separation: at fault in underlying IN PROGRESS Standby letter of credit written undertaking by a bank to pay DONE Beneficiary If the applicant defaults DONE Contractor abandons If the contractor abandons the site DONE Separation gives the beneficiary certainty ACTIVE Expiry date available balance therefore matter on every QUEUED Applicant have a credit facility or collateral QUEUED This separation gives the beneficiary certainty, because payment does not depend on a court deciding who was at fault in the underlying deal.
Expiry date PAYMENT OPERATIONS IN PROGRESS LIVE 01 Standby letter of credit - written undertaking by a bank to pay DONE 02 Beneficiary - If the applicant defaults DONE 03 Contractor abandons - If the contractor abandons the site DONE 04 Separation - gives the beneficiary certainty DONE 05 Expiry date - available balance therefore matter on every ACTIVE 06 Applicant - have a credit facility or collateral QUEUED The expiry date and the available balance therefore matter on every drawing. Step 5 of 6 Expiry date IN PROGRESS Standby letter of credit written undertaking by a bank to pay DONE Beneficiary If the applicant defaults DONE Contractor abandons If the contractor abandons the site DONE Separation gives the beneficiary certainty DONE Expiry date available balance therefore matter on every ACTIVE Applicant have a credit facility or collateral QUEUED The expiry date and the available balance therefore matter on every drawing.
Applicant must therefore PAYMENT OPERATIONS COMPLETE LIVE 01 Standby letter of credit - written undertaking by a bank to pay DONE 02 Beneficiary - If the applicant defaults DONE 03 Contractor abandons - If the contractor abandons the site DONE 04 Separation - gives the beneficiary certainty DONE 05 Expiry date - available balance therefore matter on every DONE 06 Applicant - have a credit facility or collateral ACTIVE The applicant must therefore have a credit facility or collateral in place before the bank agrees to issue the standby. Step 6 of 6 Applicant must therefore COMPLETE Standby letter of credit written undertaking by a bank to pay DONE Beneficiary If the applicant defaults DONE Contractor abandons If the contractor abandons the site DONE Separation gives the beneficiary certainty DONE Expiry date available balance therefore matter on every DONE Applicant have a credit facility or collateral ACTIVE The applicant must therefore have a credit facility or collateral in place before the bank agrees to issue the standby.

Key points of this lesson, in order.

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What a Standby Letter of Credit Is

Standby Letter of Credit, Lesson 1 of 7, Narration 2:38, D06 Cross-border payments

What you will learn

Your objective. By the end of this lesson, you will be able to explain standby letter of credit is. A standby letter of credit is a written undertaking by a bank to pay a stated amount to a named beneficiary if the applicant fails to perform a stated obligation.

Why it matters. If the applicant defaults, the beneficiary can present a demand and the required documents, and the bank must pay.

Chapter objective: Learner explains what a standby letter of credit is, distinguishes it from a commercial letter of credit, and describes issuance, notification, drawing and expiry. Learner uses real examples with amounts, banks and message names to show how the topic works in practice.

Key learning points

  • Standby letter of credit
  • Beneficiary can present
  • Contractor abandons
  • Separation: at fault in underlying
  • Expiry date
  • Applicant must therefore

Key terms

Payment flow diagram showing What a Standby Letter of Credit Is.

Insights and practice scenarios

Worked insights and practice scenarios for this lesson. Each one is a reusable PaymentForge case, so the same case may appear in more than one lesson.

Practise this lesson

Exercise

Work out what the beneficiary receives for a 500,000 dollars payment under OUR, SHA and BEN.

Use the charge arrangement rules in this lesson and the correspondent and beneficiary bank fees named in the lesson.

  1. What to do. Calculate the amount credited under each of the three arrangements and state who pays each fee.

Correct result. Under OUR the sender pays all charges and the beneficiary receives the full amount. Under SHA the sender pays the sending charges and the beneficiary pays the receiving charges. Under BEN the beneficiary pays all charges and receives the amount less all fees.

Why. The charge arrangement decides who pays and how much arrives. A customer who was promised the full amount and receives less will complain, and the complaint lands on the analyst.

Check your understanding

Practice question

A contractor must give a project owner a guarantee that the bank will pay if the contractor fails to finish the work. The contractor will not draw on it unless there is a default. Which instrument fits?

Takeaway and next step

What to remember

The applicant must therefore have a credit facility or collateral in place before the bank agrees to issue the standby.

Build a cross-border payment like the one in this lesson and watch the chain, the charges, and the final amount change.

Open the Cross-Border Payment Configurator →

Builds on "Capstone Exercise: Draw the Hub".

Transcript and full text

Show transcript

A standby letter of credit is a bank payment undertaking that is intended to be used only if the applicant fails to perform its obligation. It is a guarantee in the form of a letter of credit. The issuing bank promises the beneficiary that, if the applicant does not pay, does not perform, or does not deliver as agreed, the bank will pay the beneficiary on presentation of a demand and any documents the standby requires. The standby is a secondary undertaking, it stands behind the underlying obligation, and it is drawn upon only when the underlying obligation is not performed. That is the defining feature, and it is what separates a standby from a commercial letter of credit, which is intended to be used as the normal means of payment. A standby letter of credit is used in many situations. A contractor gives a standby to a project owner as a performance guarantee, promising that the contractor will complete the work. A tenant gives a standby to a landlord as a security deposit, promising that the tenant will pay the rent. An importer gives a standby to an exporter as a payment guarantee, promising that the importer will pay for the goods. A borrower gives a standby to a lender as a financial guarantee, promising that the borrower will repay the loan. In each case the beneficiary holds the standby as security, and it draws on it only if the applicant defaults. The standby is therefore a risk management tool, not a payment tool, and it is priced as a guarantee rather than as a payment instrument. The standby has an amount, an expiry date, and a set of drawing conditions. The amount is the maximum the bank will pay, for example USD 1,000,000. The expiry date is the last date a demand can be presented, for example 31 December 2026. The drawing conditions state what the beneficiary must present to draw, normally a written demand stating that the applicant has defaulted, and sometimes a copy of an unpaid invoice, a certificate of default, or a court order. The conditions should be simple and clear, because a complex drawing condition makes the standby hard to use and increases the risk of a discrepancy. A standby that requires a document the beneficiary cannot obtain is a standby that cannot be drawn, and it is worthless as security. The standby is independent of the underlying contract. The bank pays on presentation of a complying demand, without investigating whether the applicant really defaulted, and without waiting for a court to decide. This is the independence principle, and it is the same principle that applies to a commercial letter of credit. The bank deals in documents, not in goods or in performance. If the demand complies with the terms of the standby, the bank pays. If the applicant believes the demand is wrongful, it must take legal action against the beneficiary separately, and it cannot stop the bank from paying. An applicant who gives a standby must understand this, because it means the beneficiary can draw the standby even if the applicant disputes the default. The governing rules for a standby are either the Uniform Customs and Practice for Documentary Credits, UCP 600, or the International Standby Practices, ISP98. UCP 600 is the general rule set for letters of credit, and it applies to standby letters of credit when the standby states that it is subject to UCP 600. ISP98 is a rule set written specifically for standby letters of credit, and it is the preferred rule set for standbys in the United States and in many international transactions. The standby should state which rule set applies, and the bank, the applicant, and the beneficiary should all understand the differences. The differences are covered in the last lesson of this chapter, and they matter for the examination of the demand, the expiry, and the transfer. A standby is normally issued by MT700, the SWIFT message for the issue of a documentary credit, or by MT707 when it amends an existing credit. The MT700 for a standby carries the same fields as for a commercial letter of credit, but the terms are different. Field 40A states the form of documentary credit, and for a standby it states STANDBY. Field 41a states the available with and by, normally the issuing bank, by payment. Field 42C states the draft at, normally not applicable for a standby, because a standby is drawn by demand rather than by draft. Field 46A states the documents required, which for a standby is normally a written demand and any supporting documents. Field 47A states the additional conditions, which for a standby may include the evergreen clause, the reduction clause, or the transfer condition. An SME should remember that a standby letter of credit is a guarantee that looks like a letter of credit. It is issued by a bank, it has an amount and an expiry, it is drawn by presentation of documents, and it is governed by UCP 600 or ISP98. But its purpose is security, not payment, and it is drawn only on default. A business analyst who works on trade finance should ask, for any standby, who is the applicant, who is the beneficiary, what is the underlying obligation, what is the amount, what is the expiry, what documents are required for a drawing, and which rule set applies. Those seven questions define the standby, and they are the questions this chapter answers in detail.

A standby letter of credit is a bank payment undertaking that is intended to be used only if the applicant fails to perform its obligation. It is a guarantee in the form of a letter of credit. The issuing bank promises the beneficiary that, if the applicant does not pay, does not perform, or does not deliver as agreed, the bank will pay the beneficiary on presentation of a demand and any documents the standby requires. The standby is a secondary undertaking, it stands behind the underlying obligation, and it is drawn upon only when the underlying obligation is not performed. That is the defining feature, and it is what separates a standby from a commercial letter of credit, which is intended to be used as the normal means of payment.

A standby letter of credit is used in many situations. A contractor gives a standby to a project owner as a performance guarantee, promising that the contractor will complete the work. A tenant gives a standby to a landlord as a security deposit, promising that the tenant will pay the rent. An importer gives a standby to an exporter as a payment guarantee, promising that the importer will pay for the goods. A borrower gives a standby to a lender as a financial guarantee, promising that the borrower will repay the loan. In each case the beneficiary holds the standby as security, and it draws on it only if the applicant defaults. The standby is therefore a risk management tool, not a payment tool, and it is priced as a guarantee rather than as a payment instrument.

The standby has an amount, an expiry date, and a set of drawing conditions. The amount is the maximum the bank will pay, for example USD 1,000,000. The expiry date is the last date a demand can be presented, for example 31 December 2026. The drawing conditions state what the beneficiary must present to draw, normally a written demand stating that the applicant has defaulted, and sometimes a copy of an unpaid invoice, a certificate of default, or a court order. The conditions should be simple and clear, because a complex drawing condition makes the standby hard to use and increases the risk of a discrepancy. A standby that requires a document the beneficiary cannot obtain is a standby that cannot be drawn, and it is worthless as security.

The standby is independent of the underlying contract. The bank pays on presentation of a complying demand, without investigating whether the applicant really defaulted, and without waiting for a court to decide. This is the independence principle, and it is the same principle that applies to a commercial letter of credit. The bank deals in documents, not in goods or in performance. If the demand complies with the terms of the standby, the bank pays. If the applicant believes the demand is wrongful, it must take legal action against the beneficiary separately, and it cannot stop the bank from paying. An applicant who gives a standby must understand this, because it means the beneficiary can draw the standby even if the applicant disputes the default.

The governing rules for a standby are either the Uniform Customs and Practice for Documentary Credits, UCP 600, or the International Standby Practices, ISP98. UCP 600 is the general rule set for letters of credit, and it applies to standby letters of credit when the standby states that it is subject to UCP 600. ISP98 is a rule set written specifically for standby letters of credit, and it is the preferred rule set for standbys in the United States and in many international transactions. The standby should state which rule set applies, and the bank, the applicant, and the beneficiary should all understand the differences. The differences are covered in the last lesson of this chapter, and they matter for the examination of the demand, the expiry, and the transfer.

A standby is normally issued by MT700, the SWIFT message for the issue of a documentary credit, or by MT707 when it amends an existing credit. The MT700 for a standby carries the same fields as for a commercial letter of credit, but the terms are different. Field 40A states the form of documentary credit, and for a standby it states STANDBY. Field 41a states the available with and by, normally the issuing bank, by payment. Field 42C states the draft at, normally not applicable for a standby, because a standby is drawn by demand rather than by draft. Field 46A states the documents required, which for a standby is normally a written demand and any supporting documents. Field 47A states the additional conditions, which for a standby may include the evergreen clause, the reduction clause, or the transfer condition.

An SME should remember that a standby letter of credit is a guarantee that looks like a letter of credit. It is issued by a bank, it has an amount and an expiry, it is drawn by presentation of documents, and it is governed by UCP 600 or ISP98. But its purpose is security, not payment, and it is drawn only on default. A business analyst who works on trade finance should ask, for any standby, who is the applicant, who is the beneficiary, what is the underlying obligation, what is the amount, what is the expiry, what documents are required for a drawing, and which rule set applies. Those seven questions define the standby, and they are the questions this chapter answers in detail.

Full lesson text (all scenes)

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