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A revolving letter of credit is a guaranteed payment arrangement with a bank that is used to facilitate repeat sales transactions in international trade. In instances where importers and exporters engage in repeat purchases of the same goods over the course of time, a revolving letter of credit establishes an open draw in favor of the exporter so the importer does not have to obtain a letter of credit for each individual transaction. The importer's bank, known as the issuing bank, guarantees payment for every order under the letter for a specified length of time, as long as the exporter provides the proof of shipping or other documentary evidence required.
Letters of credit are financing tools designed to decrease the risks inherent in international trade. The reality of completing a sale by parties located in different countries is that one or the other has to absorb an unreasonable level of risk, under ordinary circumstances. The distance involved and the differences in financial systems would require the exporter, or seller, to send goods with payment made upon receipt, or for the importer, or buyer, to pay for goods in advance of shipping. In either scenario, one party is at a heightened risk of being defrauded.
Banks have taken on the role of intermediaries in the international trade financing system. Through the use of letters of credit, the bank removes the risk that is inherent in a sale because of the distance the goods have to travel. The letter is issued at the request of the buyer in favor of the seller and guarantees that the bank will pay the seller once he presents proof of shipping, regardless of any dispute of issue that may arise with the sale. Like an escrow, the money is segregated with an independent third party, waiting to be claimed once the transaction's prerequisites are met.
A revolving letter of credit is a type of letter that has certain open terms. Rather than representing just a single transaction, this letter is good for all qualifying transactions that take place during a specific time period, typically one year. Using a revolving letter can keep goods flowing smoothly between the exporter and importer, since the importer does not need to arrange for a separate letter of credit for each sales transaction.
Functionally, an importer arranges for a revolving letter of credit in much the same way as an ordinary letter. Once the importer and exporter have signed a sales contract, the importer requests a letter of credit be issued from the bank. The primary difference with a revolving letter of credit is that the bank is likely to require the importer to have certain established business credentials and better credit than necessary for a letter covering a single transaction. The open nature of the financing is riskier, and banks tend to equate good credit and business longevity with safer engagements.
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