What is a Standby Letter of Credit and How Does it work?

What is a Standby Letter of Credit and How Does it Work?

A Standby Letter of Credit (SBLC) is a financial instrument issued by a bank on instructions received from a client and is a means of payment. A SBLC can also be a guarantee of payment. 

SBLC Funding can be provided by the issuing bank if their client is deemed creditworthy. In this case the bank will issue the Standby Letter of Credit on margin. Otherwise, the bank will take sufficient collateral from the client prior to issue.

A SBLC is used here in Switzerland and worldwide. The United States of America however, do not use Bank Guarantees, only Standby Letters of Credit. A SBLC is used to underwrite trade, both domestic and international and may also be used for monetisation purposes as explained below.

A Standby Letter of Credit as a Means of Payment

As mentioned above, a SBLC is utilised to underwrite domestic and international trade deals. It is a payment of the last resort and is used when the seller/exporter feels the buyer/importer may have problems paying for goods received.

If a seller feels the buyers credit rating is not good enough, they will ask for a Standby Letter of Credit. The buyer will request their bank to open a SBLC in favour of the seller. The seller will then ship the goods to the buyer.

If the buyer pays the seller, the SBLC is cancelled and returned to the issuing bank. If the buyer fails to pay, the seller will claim the sum owed against the Standby Letter of Credit. The issuing bank will pay the seller and claim the same from the buyer.

A Standby Letter of Credit as a Guarantee of Payment or SBLC Monetisation

When an SBLC is monetised, it acts as a guarantee of payment. The verbiage within will exactly mirror that of a Demand Bank Guarantee. Both instruments will be governed by ICC Uniform Rules for Demand Guarantees, (URDG 758). They will be payable on first demand. 

If a company is looking for a loan or line of credit, they can obtain a SBLC “lease”.  They may “lease” a Standby Letter of Credit from a SBLC provider. SBLC Providers can be found in many countries including here in Geneva. 

The lessee or beneficiary will sign a contract with the SBLC Provider. This contract is referred to as a Collateral Transfer Agreement. The beneficiary will usually “lease” the Standby Letter of Credit from the SBLC Provider for one year.

The beneficiary will pay a Collateral Transfer Fee to the SBLC Provider representing the “Leasing” fee. The SBLC provider will instruct their bank to transmit the SBLC to the beneficiary’s bank. Upon receipt the beneficiary can offer their bank the SBLC as collateral for a line of credit or loan.