A financial letter of credit is essentially a legal document giving assurance to a beneficiary that a payment will be made, or a non-financial obligation – such as some kind of service – will be met.

A standby letter of credit (SLOC) is the back up plan – if the purchaser fails to live up to his or her end of the bargain, the beneficiary can then invoke the terms of the SLOC and receive due compensation.

A Powerful Financial Tool

Standby letters of credit are binding and irreversible. This means they are virtually the same as cash. The only way they can be revoked is in the case of court-proven fraud, but this rarely happens.

Types of SLOC

There are two types of standby letters of credit – Performance SLOC and Financial SLOC.

Performance – these are irrevocable undertakings that a bank makes to beneficiary, stating that they will make a payment in the event that the purchaser does not meet their non-financial contractual obligation. Such as if, for example, a contractor does not fulfill his construction contract to the developer’s satisfaction, or if he abandoned the project halfway through completion, or the finished project (a bridge or dam, for example) was unsafe.

Financial – these are similar in concept to a performance standby, but act as a guarantee of payment for financial obligations if the purchaser is unable to meet them. Companies trading on the securities markets, for example, are often required to have guarantees in place in case they are unable to settle their trades at the end of the day.

Key Conversion Differences

Whereas a performance SLOC is converted at 50% of the total transactional amount, all financial SLOCs have a 100% conversion factor – any outstanding debts are paid in full.

As can be seen, the best way to determine if a standby letter of credit is performance or financial is the contractual obligation that triggers payment. If there is a failure to pay money, for example, the SLOC can be considered financial. If there is, for example, a failure to ship a product or provide a service, the SLOC can be classified as performance.