Letters of Credit are a guarantee from a bank that a buyer’s payment to a seller will be received on time and for the correct amount. Specifically, if the buyer is no longer able to pay, the bank will be liable to cover the amount.
Parties face many challenges in international trade, including distance, transport risk, import/export restrictions, and documentation. Letters of credit offer some haven from the issues companies will face when trading overseas, and their popularity is proof of it.
When letters of Credit were first developed, there were two specific variations that caught most traction – Red and Green Letters.
Red Clause Letters of Credit
The distinctive characteristic of a Red LOC is the incorporation of a unique clause which allows the Beneficiary ( the party drawing benefit from the LOC ) to draw a pre-shipment advance against a receipt and draft.
The Beneficiary is provided with credit that may have not been otherwise available, whether that be locally or with cheaper financing.
Red Clause Letters of Credit Background
According to reputation, the Australian Wool Trade was home to the creation of Red Clause Letters. Exporters in Australia were able to draw money advances in order to purchase wool – this was possible because of the Red Clause.
Red ink was used to draw the nominated bank’s attention. However, in today’s market, the advantages associated with red clause Letters are cancelled out by an Advance Payment Guarantee.
Red Clause Letters in Practise
In reality, there will be an instruction from the importer to the advising bank. This will be for a percentage of credit that is available for advance prior to the shipment.
Furthermore, the amount will be provided in a local currency and will be against security from the exporter. The funds are repaid when the documents are presented, and goods are shipped. The amount of the Advance, plus interest and fees are deducted from the available credit.
Green Clause Letters of Credit
Green Clause Letters are an extension of the Red Letter, as it enables the advance of not only the purchase of raw materials, processing and packaging of goods but it also takes pre-shipment warehousing at the port of origin and insurance into account.
These unique Letters also require a greater amount of documentation. In addition, the bank that is issuing the Letter requires title documents in order to advance any payments. These documents are typically proof of warehouse status.
Green Clause Letters of Credit Background
The commodity sector is home to the majority of these credits. The ink used on a Green Letter was green, hence the name. They enable exporters to purchase the commodity and therefore make the product.
Key Differences Between Red and Green
- In a Red Clause, the percentage of the total letter value available for an advance is around 20-25%. In contrast, with a Green Letter of Credit the percentage is far greater – 75-80% the total value of the Letter.
- As an Importer, you have much more security if using a Green Letter of credit. This is because of the aforementioned documentation required. If importing goods, the buyer is technically providing the advance against the documentation of title.
- In a Red Letter scenario, the buyer can take an advance before the producer has made the good.
Have you seen our Letter of Credit Guide?