Introduction

In international trade, banks provide several instruments to secure payments and mitigate risk, primarily through Standby Letters of Credit (SBLCs) and traditional Letters of Credit (LCs).

While both instruments are critical for trade finance, understanding their differences, purposes, and operational nuances is essential for corporates, exporters, and banks.

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I. Definition and Purpose

Traditional Letter of Credit (LC):

• A documentary credit guaranteeing payment to the seller once specified documents are presented and verified.

• Typically used as a primary payment mechanism in trade transactions.

Standby Letter of Credit (SBLC):

• A payment guarantee issued by a bank as a last-resort instrument, payable only if the applicant fails to meet contractual obligations.

• Acts as a backup or risk mitigation tool, not the primary payment method.

Example:

• LC: Buyer pays the exporter once shipping documents are submitted.

• SBLC: Buyer defaults, and the exporter claims payment under the SBLC.

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II. Payment vs. Guarantee Function

Key Point: SBLC serves as a last-resort safety net, whereas LC ensures direct payment upon compliance.

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III. Documentary Requirements

Traditional LC:

• Requires strict document compliance (invoice, bill of lading, certificate of origin, insurance).

• Payment is processed once all documents match LC terms.

SBLC:

• Generally less document-intensive; claim is made only if the applicant defaults.

• Banks may require proof of non-performance or contractual breach.

Example: An exporter presenting compliant shipping documents under an LC receives immediate payment, whereas under an SBLC, payment occurs only if the buyer fails to pay.

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IV. Irrevocability and Legal Framework

• LCs are often irrevocable, meaning terms cannot be changed without agreement from all parties.

• SBLCs are also usually irrevocable, providing a strong risk mitigation tool, but their payment conditions are contingent, unlike the LC’s automatic payment on document compliance.

• Both instruments are governed by UCP 600 (LCs) or ISP98 (SBLCs) standards, providing international recognition and enforceability.

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V. Typical Use Cases

Traditional LC:

• Payment for goods exports.

• Finance for short-term trade transactions.

SBLC:

• Performance guarantees for construction projects.

• Bid bonds, advance payment guarantees, or insurance substitutes.

• Risk management in multi-party or cross-border deals.

Example: A construction contractor may use an SBLC to assure timely project completion, whereas a machinery exporter relies on an LC to secure payment upon shipment.

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VI. Advantages and Limitations

Advantages of LC:

• Ensures direct payment to the beneficiary.

• High document compliance reduces risk of non-payment.

Limitations of LC:

• Requires strict document submission.

• Less flexible for complex multi-party arrangements.

Advantages of SBLC:

• Provides risk mitigation for buyer or seller defaults.

• Flexible and can cover various obligations (financial, performance, insurance).

Limitations of SBLC:

• Payment is contingent, not guaranteed automatically.

• May require additional legal interpretation or proof of default.

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Conclusion

Understanding the difference between SBLC and traditional LC is essential for effective trade finance planning.

While LCs serve as primary payment instruments, SBLCs act as guarantees or backups, protecting parties against non-payment, default, or contractual risk. Choosing the right instrument depends on transaction type, risk profile, and contractual requirements.

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FAQ: SBLC vs. LC

Q1 — What is the main difference between an SBLC and a traditional LC?
LCs are primary payment instruments, while SBLCs are last-resort payment guarantees.

Q2 — When is an SBLC used instead of an LC?
For performance guarantees, bid bonds, advance payment coverage, or risk mitigation.

Q3 — Do both SBLC and LC require document compliance?
Yes, but LC requires strict document compliance for payment, while SBLC payment occurs only upon applicant default.

Q4 — Are SBLCs irrevocable like LCs?
Typically, yes, though payment under SBLC is contingent.

Q5 — Which standard governs SBLCs?
The International Standby Practices (ISP98) standardizes SBLC usage, while LCs are governed by UCP 600.

Q6 — Can SBLCs replace insurance?
Yes, in some trade and project finance scenarios, SBLCs act as an insurance substitute.

Q7 — How do banks verify claims under SBLC?
Banks require proof of non-performance, financial default, or breach of contract before honoring the SBLC.