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A letter of credit is used as a method to facilitate payment of international trade transactions (ie: the import/export of goods/services).
Unlike a trade letter of credit, a standby letter of credit is NOT meant to be used for payment. A standby letter of credit is used as a form of "back-up" guarantee (hence the name "standby") used for a variety of purposes.
There are two types of standby letters of credit: Performance Standby L.C. and Financial Standby L.C.
Performance Standby's are used to guarantee some sort of performance of a contractual obligation. For example, a construction company building a highway bridge might be required by the highway department to put up a performance standby letter of credit ensuring that they will complete the project contracted or to warranty the work. Under normal circumstances the standby would not be drawn upon, however if the contractor abandoned the project midway through completion or if the bridge were unsafe, the standby letter of credit could be drawn upon for its specified dollar amount.
A Financial Standby Letter of Credit is similar in concept to the Performance Standby, but
instead acts as a guarantee for payment of financial obligations.
For example, companies trading on securities markets are frequently required to have financial standbys in place benefiting the particular stock market exchange which can be drawn upon if they are for whatever reason unable to settle their trades at the end of the day.
Financial standby's can also be used in international trade, but in a different manner than standard letters of credit.
Normal trade letters of credit are intended to be used for pre-specified shipment(s) of goods or services. The letter of credit requires documents specifically evidencing the trade transaction itself and the letter of credit serves as the vehicle for payment of the trade transaction.
When financial standby's are used for trade purposes, they are not intended as a means of payment, but as with all standby's, act as a "back-up" guarantee.
Financial standbys frequently are used between buyers and sellers who have frequent, ongoing trade shipments for an extended period of time. The standby acts as a blanket guarantee for the overall obligations of the buyer to pay and does not contains specifics related to any one particular shipment.