Letter of Credit vs. Standby Letter of Credit
A letter of credit and a standby letter of credit are both bank-issued instruments that guarantee payment, but they are designed for fundamentally different purposes and are triggered under opposite conditions. Treating them as interchangeable is a common error with real transactional consequences.
What They Are
Documentary Letter of Credit (LC)
A commercial or documentary LC is a payment mechanism. It is designed to be drawn upon — the expectation is that the beneficiary (typically the seller/exporter) will present the required documents and receive payment as the normal course of the transaction. The bank pays when the seller presents conforming shipping documents: the bill of lading, the commercial invoice, the packing list, and any other documents specified in the LC. Payment is the intended outcome, not an exceptional one.
Documentary LCs exist because international trade between strangers involves counterparty risk. The buyer may not trust the seller to ship before payment; the seller may not trust the buyer to pay after delivery. The LC resolves this: the buyer’s bank commits to pay the seller when documents confirming shipment are presented. The bank’s creditworthiness substitutes for the buyer’s.
Standby Letter of Credit (SBLC)
A standby LC is a credit support instrument — it backstops a primary obligation rather than serving as the payment mechanism itself. The SBLC is designed not to be drawn upon. It stands by as a guarantee that if the applicant (typically the buyer or contractor) fails to perform their primary obligation, the beneficiary can draw on the SBLC as compensation.
Drawing on a standby LC signals failure. A beneficiary who presents a demand under an SBLC is declaring that the primary obligation has not been met — a contract has been breached, a loan has defaulted, a construction project has been abandoned. Banks issuing SBLCs expect most to expire undrawn.
SBLCs are used in construction contracts (guaranteeing contractor performance), loan agreements (as security for a borrower’s obligation), commercial leases (as a security deposit alternative), and utility contracts. They function similarly to bank guarantees in non-U.S. practice.
A Concrete Example
An exporter selling electronics to a buyer in another country requests a documentary LC. The buyer’s bank issues the LC, committing to pay upon presentation of a clean bill of lading and commercial invoice. The seller ships, presents documents, and is paid. The LC was the payment mechanism — it was drawn in the normal course.
The same exporter, working with a distributor under a long-term supply agreement, requires an SBLC as performance security. The distributor’s bank issues an SBLC for $2 million, payable if the distributor fails to meet minimum purchase commitments. The distributor performs; the SBLC expires unused. Three years later, the distributor defaults. The exporter draws on the SBLC — the exceptional outcome the instrument was designed to address.
Common Misconception
Both instruments are described as “letters of credit” and both involve a bank’s payment commitment, leading many to treat them as variants of the same product. The governing rules differ: documentary LCs are governed primarily by ICC UCP 600; SBLCs are governed by ISP98 (International Standby Practices) or by the UN Convention on Independent Guarantees. More importantly, the commercial logic is inverted: a documentary LC drawn is a completed transaction; an SBLC drawn is a failed one.