Trust is the only thing concerned when it comes to high-value transactions. Be it a construction contract, a large shipment, or a cross-border deal, when millions are concerned, you need more than a promise. Missed payments or defaults may hamper the entire business operation.
This may be one reason why businesses rely on standby letters of credit, aka SBLCs. SBLCs offer financial assurance that keeps your business operational. So, whether you plan to monetize SBLCsto get working capital or protect a transaction, understanding how SBLCs work should be your prime focus. So, first, learn the meaning of SBLC from below.
What is a Standby Letter of Credit?
A standby letter of credit is also known as SBLC. It is defined under global frameworks like the UCP 600 & ISP98 as an undertaking. So, it means:
- The issuer (typically a bank) offers the beneficiary a promise of payment, separate from the main contract
- A secure option, during the times when the applicant (the buyer or contractor) fails to deliver on their end
- This setup improves the applicant’s creditworthiness when the issuer’s rating is stronger
The issuing bank guarantees payment if the applicant fails to meet their obligations, no matter the underlying agreement. The beneficiary should submit documents that comply with the SBLC terms. After that, the bank is required to honour the payment. Note that most SBLCs are never drawn on and simply expire unused. An SBLC is irrevocable and can’t be amended or cancelled early unless specifically agreed otherwise. The benefits are:
- Enhances the applicant’s creditworthiness
- Collateralizes any underlying contract, obligation, or agreement
- Secure domestic and cross-border contracts
Outlining the Types of Standby Letter of Credit
SBLCs are divided into two main categories, each serving a specific purpose in commerce and contracting.
Financial SBLC
This type guarantees that payment will be made for goods or services, even if the buyer fails to pay on time. Take an example of a crude oil firm that sends a shipment with a payment expectation within 30 days. What if the buyer does not pay? In such a case, the seller draws on the SBLC. The bank covers the amount. After this, it collects from the buyer. It is especially common in global trade.
Performance SBLC
Here, the guarantee is tied to delivering a service or completing a project. If a contractor fails to finish the job as agreed, the beneficiary is compensated. It ensures the client gets their due, even if the provider drops the ball.
How Does a Standby Letter of Credit Work?
An SBLC acts like a financial insurance policy. You hope you never have to use it. However, if things go wrong, it offers security.
Businesses often request an SBLC to help secure contracts, especially where the risk of non-performance is high. The “standby” element means the bank only steps in if something goes wrong. However, the agreement must be followed precisely. A late delivery or a simple typo could be enough for the bank to deny payment.
In both cases (financial SBLC & performance SBLC), the issuing bank only pays after verifying that all conditions and documentation are met.
Who Are Involved in a Standby Letter of Credit?
SBLC involves several players with a clear role in ensuring the instrument works as intended.
Advising Bank
This is the bank that receives the SBLC and forwards it to the beneficiary. If the beneficiary doesn’t specify a preferred bank, the issuing bank selects one. While it plays a key communication role, the advising bank doesn’t have drawing authority or rights.
Applicant
Also known as the instructing party, the applicant is the one requesting the SBLC. This party enters the contract and then asks their bank to issue an SBLC in favour of their counterparty, the beneficiary. Sometimes, the applicant may not be the bank’s actual client and may rely on external credit support to get the SBLC issued.
Beneficiary
The beneficiary is the party that benefits from the SBLC. They’re the ones who can request payment, accept changes, or reject amendments. If the applicant fails to meet their obligations, the beneficiary can draw funds as outlined in the SBLC terms.
Confirming Bank
Sometimes, beneficiaries want extra assurance. At the issuer’s request, a confirming bank may be added. This bank takes on the obligation to honour the payment if the terms are met. It offers security, especially useful in international or high-risk deals.
Issuer or Issuing Bank
This is the bank that creates and sends the SBLC. Their obligation is legally separate from the contract it supports. Because SBLCs are independent undertakings, this bank is responsible for paying if the applicant defaults, assuming documentation matches the SBLC terms.
Nominated Bank
This bank may be authorized to pay, negotiate, or honour the SBLC if it receives proper documentation. However, unless they’re also the confirmer, they’re under no obligation to do so. Most SBLCs are only payable by the issuer directly.
Monetizing SBLC – Top Things to Consider
For many businesses, having a standby letter of credit on hand is only part of the equation. The real advantage comes when you can monetize it.
Monetizing SBLC is nothing but converting a valid standby letter of credit into liquid funds. This is typically done through a financial institution or a specialist monetizer. It lets companies unlock working capital for operational needs, investment plans, or project financing.
But not all SBLCs are created equal. To be eligible for monetization, it must be issued by a reputable institution.
A Concluding Thought
Banks in the U.S. haven’t always had the broad authority to issue independent guarantees. But they’ve long had the power to issue letters of credit. Over time, these traditional LCs were adapted, changing the required documents from invoices and shipping papers to default notices and payment demands.
That transformation resulted in the rise of SBLCs: flexible, secure, and entirely independent financial undertakings. They’ve become essential to large-scale business across borders.
Whether you’re protecting against risk or looking to monetize SBLCs for capital, understanding SBLCs helps you improve the right financial strategy. But you should always remember that selecting the top SBLC providers helps you move forward accordingly.
