Definition of an Irrevocable Letter Of Credit

An irrevocable letter of credit is official correspondence from a bank that guarantees payment for goods or services being purchased by the individual or entity, referred to as the applicant, that requests the letter of credit from an issuing bank. An irrevocable letter of credit cannot be canceled, nor in any way modified, except with the explicit agreement of all parties involved: the buyer, the seller and the issuing bank. For example, the issuing bank does not have the authority by itself to change any of the terms of an irrevocable letter of credit once it is issued.

Purpose of an Irrevocable Letter of Credit

Irrevocable letter of credit are most commonly used to facilitate international trade because of the additional credit risk involved when two parties unfamiliar with each other are transacting business across national borders. An irrevocable letter of credit assures the seller of receiving payment because it is a guarantee by the issuing bank, the buyer’s bank, that it will make payment in the event the buyer fails to do so. By providing the seller with an assurance of payment, an irrevocable letter of credit also assists the buyer in arranging a transaction that the seller might otherwise be reluctant to make.

How an Irrevocable Letter of Credit Works

sblc_slocAn irrevocable letter of credit is a means of facilitating a transaction between a buyer and seller with the assistance of their respective banks. The buyer requests an irrevocable letter of credit from his bank, which is then sent to the seller’s bank. In addition to providing credit risk protection, a letter of credit typically also specifies important details of the transaction, such as price, payment terms, and time and place for delivery of goods. In the event the buyer fails to make payment as agreed, the buyer’s bank makes payment to the seller’s bank, which in turn renders payment to the seller, the beneficiary of the irrevocable letter of credit.

Irrevocable letter of credit may be either confirmed or unconfirmed. A confirmed irrevocable letter of credit offers additional risk protection for the seller by providing a guarantee of payment from both the buyer’s bank and the seller’s bank. With an unconfirmed irrevocable letter of credit, the seller’s bank has no liability for payment and essentially serves only as a go-between to transfer payment to the seller from the buyer’s bank.