What is a Transferable Letter of Credit and How Does it Work?
What is a Transferable Letter of Credit?
A Transferable Letter of Credit is a letter of credit facility where the first beneficiary can transfer some or all of the credit to another party, known as the second beneficiary. This type of letter of credit gives the seller/exporter the authority to instruct the bank to pay or make the credit available completely or partly to one or more secondary beneficiaries.
Transferable Letter of Credit DefinitionLet’s understand the meaning of Transferable LC in simple words. A transferable letter of credit is a trade finance instrument that allows the first or original beneficiary to transfer some or all the right of payment to another party, which creates a second beneficiary.
The party that initially accepts the transferable letter of credit issued by the importer’s bank is referred to as the first, or primary beneficiary. A transferable LC is often used in international trade transactions to ensure timely payment to the supplier or manufacturer.
1. The ultimate agenda of a transferable Letter of credit is to enable the original or initial beneficiary to transfer the right of payment to another beneficiary which they owe.
2. The first beneficiary is authorized to transfer part or all of the right of payment to a second beneficiary.
3. Since applying for a letter of credit is a much more detailed process and can lead to payment delays and additional fees, issuance of a transferable LC ensures sound cash flow for third-party manufacturers.
4. The parties involved in a transferable letter of credit, in addition to the bank, include the applicant (the buyer of goods/service), the first beneficiary (A retailer or broker), and the second beneficiary (A supplier or manufacturer).
How Does a Transferable Letter of Credit Work?As we know that a letter of credit is a legal document issued by a bank, guaranteeing that a seller will receive the payment from a buyer on time for delivered goods or services. If the buyer fails to do so, the issuing bank will compensate the seller.
When you apply for a transferable LOC, it should be strictly mentioned as such by the issuing bank. By obtaining a transferable letter of credit, the first beneficiary is capable of transferring an LC to another, who then is known as the second beneficiary.
Once named as a second beneficiary, it possesses all the same rights as the original does. The original beneficiary then can request the bank to transfer a part or all the credit to the second beneficiary.
This second beneficiary might, for example, be a supplier or manufacturer that the seller is relying on to send the ordered goods to the buyer. In this type of arrangement, the first beneficiary is acting as a sort of middleman between the buyer and the third-party supplier. Thereby, there can be more than one secondary beneficiary.
In an LC agreement, a seller (first beneficiary) has a sale to execute with the buyer but is unable to complete the merchandise order from the manufacturer. By transferring a portion of transferable letters of credit to the manufacturer, ie. third-party supplier, the seller provides them an assurance of payment by leveraging the buyer’s banker’s credit and utilizes this LC to purchase those goods on time.
How to Apply for a Transferable Letter of Credit?The process of applying for a transferable LOC is almost the same as applying for a loan. Here are a few steps to follow:
Step 1 - Buyer Requests
The buyer/importer must submit an application to its bank with a request to issue a transferable letter of credit in favor of the exporter/seller.
Step 2 - Evaluation By Buyer’s Bank
The bank will then analyze & evaluate the buyer’s credit score and financial stability in the underwriting process. Underwriting is simply a procedure banks conduct to assess how much risk a borrower poses and determine whether to grant them credit or not.
Step 3 - Review By Exporter’s Bank
After the approval, the bank will draft the transferable LC based on the terms & conditions mentioned in the sales agreement. Then it forwards the LC to the exporter’s bank which then further checks for any discrepancies and sends it to the exporter.
Step 4 - Shipment of Goods
After getting the LC, the exporter will then ship the goods to the buyer and submit the necessary documents to its bank.
Step 5 - Exporter’s Bank Forwards The Documents
The exporter’s bank reviews the submitted documents by its client, ie. the exporter to make sure they comply with the terms & conditions of the LC contract. If any errors or discrepancies occur, they get fixed. Once the documents are approved, the exporter’s bank will forward them to the buyer’s bank.
Step 6 - Release of Payment
The buyer’s bank checks the documents thoroughly and checks the delivery of goods with the buyer. If everything seems right, the bank releases payment to the exporter’s bank and later collects the same from the buyer.
Transferable Letter of Credit Vs Confirmed Letter of CreditA transferable LC is a much more convenient & favorable option for the buyer than a confirmed LC. It’s because the buyer is only required to interact with one bank for a transferable LOC.
While in the case of a Confirmed letter of credit, the buyer must obtain two letters of credit to provide an additional payment guarantee to the seller, with the second one guaranteeing the first one. This type of trade finance instrument is issued in cases where the seller isn’t assured of getting payment from the first bank (buyer’s bank). In such a case, a second bank that the seller is familiar with issues an LC to support the first one.
Transferable Letter of Credit Vs Back-to-Back Letter of CreditA Back-to-Back Letter of Credit involves the issuance of two letters of credit to finance a single transaction when a middleman is involved between the buyer and seller, such as a retailer or broker. It enables the first beneficiary to transfer the original LC as a payment security in favor of the second beneficiary, ie. the supplier.
But a Back-to-Back LC is a bit different from a transferable letter of credit. Here, Instead of issuing an LC to the supplier, the first beneficiary requests the buyer to issue a transferable LC in favor of the second beneficiary.
Transferable Letter of Credit Vs Non-Transferable Letter of CreditAn LC can be transferable or non-transferable. If a bank issues a transferable LC, the word “Transferable” is mentioned on it. In the absence of such a word, an LC is deemed to be a non-transferable LC.
A transferable LC is often used in international trade transactions to provide timely payment assurance to the supplier or manufacturer. Letters of credit are an important trade finance tool in business transactions between buyers and sellers, especially if the parties reside in different nations or there is a lack of trust. Transferable letters assure both the sellers and their suppliers that they will be paid for their goods & services.