What is a clean letter of credit? (with photo)

Importers and exporters often use a clean letter of credit to transfer funds.

A clean letter of credit allows the applicant to issue minutes that must be paid in cash by the bank, with no additional documentation required. These documents are often used in international trade to provide a mechanism for importers to pay exporters for their goods. They can arise in other commercial and business contexts as well. This is in contrast to a documentary letter of credit, where supporting material is needed before a bank pays with a letter of credit.

The process of obtaining a clean letter of credit begins with an application to a bank that offers this service. Applicants provide documentation to demonstrate their creditworthiness and explain how they plan to use the letter of credit. The bank may review this information to determine whether to grant the request and how much credit to offer. This is usually based on a reasonable ability to repay, and the letter of credit may be renewable each year to allow the bank to review the customer periodically to confirm that the credit limit is still appropriate.

Once traders have a clean letter of credit in hand, they can start approaching sellers. They negotiate a contract, basing the sale price and other arrangements on the existence of the letter of credit to finance the purchase. After the contract is finalized, the buyer can write a draft demanding payment and send it to the bank. The buyer’s bank, in turn, informs the seller that his customer has drawn the letter of credit and the funds will arrive to cover the purchase. They can be kept until the goods arrive to protect the buyer.

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Clean letters of credit are irrevocable within the issuance term. They will remain good until the review period arrives. Since banks don’t want to take any chances, they can keep the credit limit low for the first year, until they are satisfied that the customer can pay the withdrawals drawn against the clean letter of credit. In the second year, the bank can increase or decrease the limit and can adjust it later.

Companies that use a clean letter of credit in commerce must protect the document well. Counterfeit drafts would allow the bank to issue money to a beneficiary without any supporting information, as per the terms of the letter of credit. Banks typically examine drafts for signs that they are fake or altered in some way, but they don’t always spot problems, and there can be a growl as the bank retrieves the funds and files charges against the parties involved. During this time, the letter of credit may be temporarily inaccessible.

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