What Is an Irrevocable Letter of Credit (ILOC)?
An irrevocable letter of credit (“ILOC”) is an official correspondence from a banking institution that guarantees payment for goods or services being purchased by an individual or entity. Such individual or entity is referred to as the applicant. The banking institution that receives the request and aaccepts same is referred to as the issuing bank.
An irrevocable letter of credit cannot be cancelled, nor in any way modified, except with the explicit agreement of all parties involved: the buyer, the seller, and the issuing bank. For example, the issuing bank does not have the authority by itself to change any of the terms of an ILOC once it is issued.
Understanding Irrevocable Letters of Credit
Although an ILOC is irrevocable while it is in force, generally the time period during which a proposed transaction is expected to be completed, an ILOC expires at a specified point in time, which is noted in the letter of credit.
Irrevocable letters of credit are official bank correspondence transferred and authenticated through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking system. This is a global setup for facilitating financial transactions between banks or other financial institutions, and an ILOC is transmitted as MT700—message type 700.
An ILOC provides greater security of payment to the beneficiary of the letter, who is commonly the seller in a transaction. ILOCs are frequently sought for large construction projects because they are not subject to claims of preference in the event of a bankruptcy.
Widely Used in International Business Transactions
ILOCs are most commonly used to facilitate international trade because of the additional credit risk involved when two parties unfamiliar with each other are transacting business across national borders. An ILOC assures the seller of receiving payment because it is a guarantee by the issuing bank, the buyer’s bank, that it will make payment in the event the buyer fails to do so. By providing the seller with an assurance of payment, an ILOC also assists the buyer in arranging a transaction that the seller might otherwise be reluctant to make.
How an ILOC Works
An ILOC is a means of facilitating a transaction between a buyer and seller with the assistance of their respective banks. The buyer requests an ILOC from his bank, which is then sent to the seller’s bank. In addition to providing credit risk protection, an ILOC typically also specifies important details of the transaction, such as price, payment terms, and time and place for delivery of goods. In the event the buyer fails to make payment as agreed, the buyer’s bank makes payment to the seller’s bank, which in turn renders payment to the seller, the beneficiary of the ILOC.
ILOCs can also be either confirmed or unconfirmed:
- A confirmed ILOC offers additional risk protection for the seller by providing a guarantee of payment from both the buyer’s bank and the seller’s bank.
- An unconfirmed ILOC means that the seller’s bank has no liability for payment and essentially serves only as a go-between to transfer payment to the seller from the buyer’s bank.