Confirmed letter of credit: Meaning, Criticisms & Real-World Uses

A confirmed letter of credit (CLC) is a type of documentary credit in the realm of Trade Finance that adds a second, independent payment guarantee from a confirming bank. This financial instrument is primarily used in international trade to mitigate the payment risk for the exporter (beneficiary) by ensuring payment even if the issuing bank, often in a less financially stable country, defaults. A confirmed letter of credit essentially provides two promises of payment: one from the issuing bank (on behalf of the importer or applicant) and another from a separate, usually more creditworthy, confirming bank.

History and Origin

The concept of a letter of credit, from which the confirmed letter of credit evolved, dates back to ancient civilizations. Early forms of credit documents were used by merchants in Mesopotamia and Egypt around 3000 BC to facilitate long-distance trade and ensure payment without the need to transport physical gold or currency across dangerous routes.¹⁴,¹³ During the Middle Ages, European merchants and bankers refined these instruments to support increasingly complex and expansive trade networks.¹²

The modern letter of credit gained significant prominence with the rise of global commerce and the Industrial Revolution, as trade volumes surged and transactions became more intricate.¹¹ A pivotal development was the standardization of rules governing these instruments to foster uniformity and trust across borders. In 1933, the International Chamber of Commerce (ICC) introduced the first Uniform Customs and Practice for Documentary Credits (UCP), providing a voluntary framework for banks worldwide.,¹⁰ The UCP has undergone several revisions, with the latest version, UCP 600, effective since July 1, 2007.⁹, The confirmed letter of credit emerged as a vital enhancement within this framework, offering an additional layer of security, particularly when the creditworthiness of the issuing bank or the political and economic stability of the importer's country was a concern.

Key Takeaways

A confirmed letter of credit provides an irrevocable payment undertaking from both the issuing bank and a confirming bank.
It significantly reduces the payment risk for the exporter by adding the guarantee of a second bank, typically in the exporter's country or a more stable financial center.
Confirmed letters of credit are crucial in transactions involving importers or issuing banks in regions perceived as having higher commercial or political risk.
The confirming bank charges a fee for assuming this additional risk and providing its guarantee.
The terms and conditions for payment must still be strictly adhered to by the exporter for the confirming bank to honor its commitment.

Interpreting the Confirmed Letter of Credit

Interpreting a confirmed letter of credit primarily revolves around understanding the enhanced security it offers to the beneficiary, typically the exporter. When an exporter receives a confirmed letter of credit, they can be confident that two distinct banks, the issuing bank and the confirming bank, are obligated to make payment, provided the terms and conditions of the credit are met. This dual commitment effectively de-risks the transaction for the exporter, shifting the counterparty risk from potentially unknown or less creditworthy entities to a known, reputable confirming bank.,⁸

The presence of a confirming bank's undertaking implies a higher degree of assurance regarding payment, even in scenarios where the issuing bank or the importer might face financial distress or where there are political uncertainties in the importer's country. The exporter's reliance shifts to the creditworthiness of the confirming bank, which is often a major international financial institution. This added security can influence the exporter's pricing strategies and willingness to enter into trade agreements with new or unfamiliar buyers.⁷

Hypothetical Example

Imagine an American company, "Global Solar Inc.," (the exporter/beneficiary) selling a large shipment of solar panels to "EcoBuild Ltd." (the importer/applicant) in a developing country known for occasional economic instability. EcoBuild Ltd. applies to its local bank, "Frontier Bank" (the issuing bank), to open a letter of credit in favor of Global Solar Inc.

Global Solar Inc., being cautious about payment certainty, requests a confirmed letter of credit. Frontier Bank then asks "New York Finance Corp." (the confirming bank), a large, reputable bank in the U.S. with whom Global Solar Inc. already banks, to add its confirmation.

Agreement: Global Solar Inc. and EcoBuild Ltd. agree on a sales contract for $500,000, with payment via a confirmed letter of credit.
LC Issuance Request: EcoBuild Ltd. applies to Frontier Bank to issue an irrevocable letter of credit.
Confirmation Request: Frontier Bank forwards the letter of credit to New York Finance Corp., requesting them to add their confirmation. New York Finance Corp. assesses Frontier Bank's creditworthiness and the country risk.
Confirmation: New York Finance Corp. agrees and adds its irrevocable confirmation, sending the confirmed letter of credit to Global Solar Inc.
Shipment: Global Solar Inc. ships the solar panels and gathers all required shipping and commercial documents, such as the bill of lading and commercial invoice, as stipulated in the letter of credit.
Document Presentation: Global Solar Inc. presents the compliant documents to New York Finance Corp.
Payment: New York Finance Corp. examines the documents. If they are compliant, New York Finance Corp. pays Global Solar Inc. the $500,000. New York Finance Corp. then seeks reimbursement from Frontier Bank.
Reimbursement & Goods Release: Frontier Bank reimburses New York Finance Corp. and then collects payment from EcoBuild Ltd., releasing the documents necessary for EcoBuild Ltd. to claim the solar panels.

In this scenario, even if Frontier Bank faces financial difficulties or if there are political disruptions in EcoBuild Ltd.'s country preventing Frontier Bank from honoring its commitment, New York Finance Corp. is still obligated to pay Global Solar Inc., providing significant peace of mind.

Practical Applications

Confirmed letters of credit are widely used in situations where the exporter seeks maximum payment security, particularly in international trade. Key applications include:

Emerging Markets Trade: When dealing with importers located in countries with less stable economic or political environments, a confirmed letter of credit can bridge the trust gap by bringing in a highly reputable confirming bank from a more stable jurisdiction.⁶
New Trading Relationships: For exporters engaging with new overseas buyers where a long-standing relationship and established trust are absent, a confirmed letter of credit provides a robust assurance of payment.⁵
High-Value Transactions: For large or critical shipments, the added layer of security from a confirming bank minimizes the financial exposure of the exporter to default risk from the issuing bank.
Supplier Financing: An exporter might be able to obtain more favorable trade finance from their own bank if the letter of credit is confirmed by a bank known to them, as the bank's risk is lower. The Export-Import Bank of the United States (EXIM Bank) offers programs, such as its Letter of Credit Insurance policy, to reduce banks' risks on confirmations and negotiations of irrevocable letters of credit, thereby facilitating U.S. exports.⁴

Limitations and Criticisms

Despite the enhanced security, confirmed letters of credit have certain limitations and can incur additional costs.

One significant drawback is the cost. The confirming bank charges a fee for its service, which covers the risk assessment and the undertaking of the payment obligation. This fee is typically a percentage of the letter of credit amount and can add to the overall transaction cost, which is usually borne by the importer, or sometimes negotiated between the parties.³

Another limitation is the complexity and strict compliance required. All parties involved, especially the exporter, must meticulously adhere to every condition and provide precisely the specified documents. Any discrepancies, no matter how minor, can lead to the confirming bank (or the issuing bank) refusing to honor the credit until corrections are made, causing delays and potentially additional fees.² While the ICC's UCP 600 rules have somewhat relaxed standards for trivial discrepancies, strict compliance remains paramount.¹

Furthermore, even with a confirmed letter of credit, the exporter is still exposed to the commercial risk of the importer failing to fulfill their side of the underlying sales contract (e.g., refusing to accept goods despite documents being compliant). The confirmed letter of credit only guarantees payment against compliant documents, not against the ultimate success of the commercial venture. Finally, while confirming banks typically mitigate significant risks, they are not entirely immune to systemic financial crises or unforeseen events, though this risk is generally considered very low when dealing with highly-rated institutions.

Confirmed Letter of Credit vs. Standby Letter of Credit

The distinction between a confirmed letter of credit and a standby letter of credit (SBLC) is crucial in understanding their respective functions in finance. While both are issued by banks and provide a form of guarantee, their primary purposes and triggers for payment differ significantly.

A confirmed letter of credit is a primary payment mechanism. It is intended to be drawn upon as the expected means of payment for goods or services, provided the beneficiary presents documents that strictly comply with the terms of the credit. The confirming bank adds its direct undertaking to pay, essentially taking on the risk of the issuing bank's failure. It acts as an assurance of payment for a completed trade transaction.

In contrast, a standby letter of credit is a secondary payment mechanism, acting more like a financial guarantee or a "safety net." An SBLC is not expected to be drawn upon in the normal course of business. Instead, it is triggered only if the applicant (typically the buyer) fails to fulfill a contractual obligation to the beneficiary (typically the seller or another party). Payment under an SBLC occurs only upon the presentation of documents proving a default or non-performance by the applicant, such as a statement from the beneficiary asserting non-performance. It secures contractual performance rather than facilitating direct payment for goods shipped.

FAQs

What does "confirmed" mean in a letter of credit?

"Confirmed" means that a second bank, known as the confirming bank, adds its independent and irrevocable promise to pay the exporter, in addition to the promise made by the issuing bank. This provides an extra layer of security for the exporter.

Who benefits most from a confirmed letter of credit?

The exporter (beneficiary) benefits most from a confirmed letter of credit. It significantly reduces their credit risk and country risk, as they are assured payment by a second, often more creditworthy, bank, even if the issuing bank or the importer defaults.

Is a confirmed letter of credit irrevocable?

Yes, a confirmed letter of credit is inherently irrevocable. Both the issuing bank's and the confirming bank's undertakings to pay are firm and cannot be canceled or amended without the consent of all parties, especially the beneficiary. This irrevocability is a fundamental feature of most commercial letters of credit under the Uniform Customs and Practice for Documentary Credits (UCP 600) rules.

How does the confirming bank get paid?

The confirming bank charges a fee for its service, which is typically agreed upon before the letter of credit is issued. This fee is compensation for taking on the additional payment risk and is often covered by the importer as part of the transaction costs. After paying the exporter, the confirming bank seeks reimbursement from the issuing bank.

Can a letter of credit be confirmed by any bank?

No, a letter of credit can only be confirmed by a bank that the issuing bank requests to do so, and that confirming bank must agree to add its confirmation. The confirming bank will assess the creditworthiness of the issuing bank and the associated country risk before deciding whether to provide its confirmation.