What Is Revocable Letter of Credit?
A revocable letter of credit is a financial instrument in trade finance that can be amended or canceled by the issuing bank at any time without prior notice to or consent from the beneficiary (typically the seller or exporter). Unlike its more common counterpart, this type of letter of credit offers minimal security to the beneficiary, as the payment undertaking is not firm. While it provides flexibility for the buyer (applicant), the inherent uncertainty means revocable letters of credit are rarely used in international trade today.
History and Origin
The concept of a letter of credit, which provides a bank's assurance of payment, has roots tracing back to ancient civilizations such as Mesopotamia and Egypt, evolving through medieval Europe to facilitate long-distance commerce by reducing the risks associated with transporting physical currency4. Over centuries, these instruments became increasingly formalized. A significant standardization effort began in 1933 when the International Chamber of Commerce (ICC) introduced the first Uniform Customs and Practice for Documentary Credits (UCP). These internationally recognized rules, periodically revised, govern the issuance and use of documentary credits worldwide, with the current version being UCP 600, effective since July 1, 20073. Historically, earlier versions of the UCP did permit revocable letters of credit, but their use gradually diminished due to the inherent lack of security for the seller, leading to their near obsolescence in modern practice.
Key Takeaways
- A revocable letter of credit can be modified or canceled by the issuing bank without the beneficiary's consent.
- This instrument offers minimal payment security to the exporter due to its changeable nature.
- It is largely obsolete in contemporary international trade, having been replaced by more secure options.
- The terms of revocable letters of credit were historically governed by earlier versions of the Uniform Customs and Practice for Documentary Credits (UCP).
- Their rarity stems from the significant credit risk they impose on the seller.
Interpreting the Revocable Letter of Credit
Interpreting a revocable letter of credit primarily involves understanding its fundamental lack of a guaranteed payment obligation. For an exporter, receiving a revocable letter of credit means that the issuing bank's promise to pay can be withdrawn at any point before payment is made, even after goods have been shipped or documents presented. This provides substantial latitude to the buyer or their bank, enabling them to adjust the payment terms or cancel the transaction entirely without penalty or consent from the seller. Consequently, from the perspective of a seller seeking payment assurance, a revocable letter of credit offers little more security than an open account transaction where the buyer simply promises to pay at a later date.
Hypothetical Example
Consider "Alpha Exports," a textile manufacturer in Vietnam, agreeing to sell a large shipment of fabric to "Beta Imports," a clothing company in the United States. Beta Imports' bank issues a revocable letter of credit in favor of Alpha Exports for $100,000, contingent on Alpha Exports presenting a commercial invoice and a bill of lading.
- Issuance: Beta Imports' bank (the issuing bank) issues the revocable letter of credit.
- Shipment: Alpha Exports ships the fabric and prepares the required documents.
- Revocation: Before Alpha Exports can present the documents to its bank for payment, Beta Imports decides, for internal reasons or market changes, that it no longer needs the fabric. Beta Imports' bank, acting on its client's request or its own discretion (as the letter of credit is revocable), cancels the letter of credit without notifying Alpha Exports.
- No Payment: When Alpha Exports presents the documents, they are informed that the revocable letter of credit has been canceled, and thus, the bank is no longer obligated to pay. Alpha Exports must then directly pursue payment from Beta Imports, losing the bank's assurance and potentially incurring significant financial loss and additional costs related to the shipment or retrieval of goods. This scenario highlights why such instruments are rarely used in modern international trade.
Practical Applications
While largely obsolete in direct payment assurances for sellers, the underlying concept of revocability might be seen in other, less formal financial arrangements or specific clauses within broader trade finance agreements where flexibility for one party is paramount. Historically, or in very niche low-trust/low-value domestic scenarios, a revocable letter of credit might have been considered where the applicant needed to retain absolute control over the payment commitment. However, the prevalence of more secure instruments like bank guarantees and irrevocable letters of credit has rendered the revocable version impractical for mitigating risk in international transactions. According to the International Trade Administration, trade finance techniques are crucial for mitigating risks in international trade and ensuring payment for exporters while assuring delivery for importers2.
Limitations and Criticisms
The primary limitation and criticism of a revocable letter of credit is its inherent lack of security for the beneficiary. Unlike other payment mechanisms, the issuing bank holds the unilateral power to amend or cancel the revocable letter of credit at any point without needing consent from the seller or buyer. This means that an exporter could ship goods and present documents, only to find the payment obligation revoked, leaving them exposed to significant credit risk and the burden of directly pursuing the buyer for payment. The purpose of a letter of credit is to provide payment assurance, and a revocable letter of credit fundamentally undermines this assurance, making it a very risky and therefore rarely used instrument in modern international trade1. Its lack of security effectively negates the core benefit that a letter of credit is intended to provide.
Revocable Letter of Credit vs. Irrevocable Letter of Credit
The distinction between a revocable letter of credit and an irrevocable letter of credit is fundamental in trade finance and lies in their modifiability and the security they offer.
A revocable letter of credit, as discussed, can be altered or canceled by the issuing bank without prior consent from the beneficiary (seller). This flexibility for the buyer comes at the cost of high risk for the seller, as the payment guarantee is unstable and can be withdrawn unexpectedly. Consequently, revocable LCs are rarely used in current international trade due to the uncertainty they create for the seller.
In contrast, an irrevocable letter of credit is a firm undertaking by the issuing bank to pay the beneficiary, provided all stipulated documents are presented in compliance with the terms and conditions of the credit. Crucially, an irrevocable letter of credit cannot be amended or canceled without the mutual agreement of the issuing bank, the beneficiary, and the applicant (buyer). This immutability provides a much higher level of security and assurance to the seller, making it the standard and preferred choice for international transactions where payment guarantees are essential. The security of the irrevocable letter of credit ensures that the seller can proceed with production and shipment with confidence in receiving payment.
FAQs
Why is a revocable letter of credit rarely used today?
A revocable letter of credit is rarely used because it offers almost no payment security to the seller. The issuing bank can cancel or change its terms at any time without the seller's approval, defeating the primary purpose of a letter of credit as a payment guarantee.
Who benefits most from a revocable letter of credit?
The applicant (buyer) benefits most from a revocable letter of credit, as it provides them with maximum flexibility. They can request their bank to cancel or amend the credit terms if their needs change, without needing the seller's consent. However, this comes at a significant cost of security for the beneficiary.
Are revocable letters of credit governed by UCP 600?
No, the current version of the Uniform Customs and Practice for Documentary Credits (UCP 600) does not recognize or govern revocable letters of credit. UCP 600 applies only to irrevocable letters of credit, reflecting the current practice in international trade where firm payment undertakings are required. Earlier versions of the UCP did make provisions for revocable credits, but these are no longer in effect under UCP 600.
What alternatives offer more security than a revocable letter of credit?
Far more secure alternatives include the irrevocable letter of credit, confirmed letters of credit, documentary collection (though with less bank commitment than LCs), and bank guarantees. These instruments provide varying degrees of payment assurance, all significantly greater than a revocable letter of credit.