Standby vs Commercial Letter of Credit

A standby letter of credit and a commercial letter of credit look similar, because both are bank payment undertakings issued in the form of a letter of credit, governed by UCP 600 or ISP98, and drawn by presentation of documents. But their purpose, their trigger, their usage, and their cost are different, and an SME must be able to explain the difference clearly, because a client who confuses them will use the wrong instrument and will pay the wrong price for the wrong protection. The purpose is the first difference. A commercial letter of credit is intended to be used as the normal means of payment. The exporter ships the goods, presents the documents, and is paid by the bank. The letter of credit is the payment mechanism, and it is expected to be drawn. A standby letter of credit is intended NOT to be used. It is security, held by the beneficiary in case the applicant defaults. The beneficiary hopes never to draw it, and the applicant hopes never to have it drawn. The standby is a guarantee, and the commercial letter of credit is a payment instrument. That distinction drives everything else. The trigger is the second difference. A commercial letter of credit is triggered by the presentation of documents that show the goods were shipped, such as the bill of lading, the commercial invoice, and the certificate of origin. The bank examines the documents for compliance with the letter of credit, and pays if they comply. A standby is triggered by a demand stating that the applicant has defaulted, plus any documents the standby requires, which are normally a written demand and sometimes a certificate of default or a copy of an unpaid invoice. The bank does not examine shipping documents, because there are no goods to ship. It examines the demand, and pays if the demand complies with the standby terms. The usage frequency is the third difference. A commercial letter of credit is drawn in most cases, because the exporter ships and presents the documents as part of the normal trade. A standby is drawn in a small minority of cases, because most applicants perform their obligations, and the beneficiary has no reason to draw. The bank therefore prices the two instruments differently. A commercial letter of credit carries an issuance fee and a negotiation fee based on the amount and the period. A standby carries an issuance fee, often a percentage per annum on the amount, and a much lower expectation of payment. The standby fee is a guarantee fee, and it is charged for the period the standby is outstanding, whether or not it is drawn. The documents are the fourth difference. A commercial letter of credit requires a full set of shipping documents, and the bank examines each one for compliance with the UCP 600 articles on documents. A standby requires a demand and, at most, a small number of supporting documents. The examination is simpler, and the risk of a discrepancy is lower, because there are fewer documents to examine. But the consequence of a discrepancy is the same, the bank will refuse to pay if the demand does not comply with the standby terms. A beneficiary who presents a demand with a wrong amount, a wrong reference, or a missing signature will have the demand refused, and will need to present a corrected demand before the expiry date. The accounting treatment is the fifth difference. A commercial letter of credit, when issued, creates a contingent liability for the issuing bank, and the bank records it as an off-balance sheet item. A standby also creates a contingent liability, and it is also recorded off-balance sheet. But the capital treatment differs, because the risk weight for a standby that guarantees performance is different from the risk weight for a commercial letter of credit that finances trade. The bank capital team must classify the standby correctly, and the applicant must understand that the standby consumes its credit limit, even though it may never be drawn. A standby for USD 1,000,000 uses USD 1,000,000 of the applicant credit limit, just as a loan would, and the applicant cannot use that limit for another purpose while the standby is outstanding. Here is a side by side comparison. Commercial letter of credit, purpose, payment for goods, trigger, presentation of shipping documents, expected usage, usually drawn, documents, full set of shipping documents, cost, issuance and negotiation fees, risk, bank pays on complying documents. Standby letter of credit, purpose, security for performance or payment, trigger, demand stating default, expected usage, rarely drawn, documents, demand plus at most a few supporting documents, cost, guarantee fee per annum, risk, bank pays on complying demand. An SME who can reproduce this comparison, and explain each line, can advise a client on which instrument to use, and can explain why a standby is cheaper than a commercial letter of credit for a guarantee, and why a commercial letter of credit is the right instrument for a payment. For a business analyst, the requirement must state which instrument is being built. The requirement should say whether the system handles a commercial letter of credit, a standby letter of credit, or both, and it should state the differences in the fields, the documents, the examination, and the fees. A system built for a commercial letter of credit that is used for a standby will ask for shipping documents that do not exist, and will fail. A system built for a standby that is used for a commercial letter of credit will not capture the shipping documents, and will fail. The instrument type is a fundamental design decision, and it must be stated at the start of the requirement.