What Is a Clean Letter of Credit?

A clean letter of credit allows an applicant to issue drafts which must be paid on demand by the bank, without additional required documentation. Such documents are used frequently in international trade to provide a mechanism for importers to pay exporters for their goods. They may come up in other trade and business contexts as well. This contrasts with a documentary letter of credit, where supporting material is necessary before a bank will pay out on a letter of credit.

The process of getting a clean letter of credit starts with an application to a bank that offers this service. Applicants provide documentation to demonstrate their creditworthiness and explain how they plan to use the letter of credit. The bank can review this information to determine whether it wants to grant the request, and how much credit to offer. This is typically based on a reasonable ability to repay, and the letter of credit may be renewable every year to allow the bank to review the customer periodically to confirm the credit limit is still appropriate.

Once traders have a clean letter of credit in hand, they can start to approach sellers. They negotiate a contract, basing the sales price and other arrangements on the existence of the letter of credit to finance the purchase. After finalization of the contract, the buyer can write out a draft demanding payment, and send it to the bank. The buyer's bank in turn advises the seller's that the its client has drawn upon the letter of credit, and funds will arrive to cover the purchase. They may be held until the goods arrive to protect the buyer.

Clean letters of credit are irrevocable within the term of issue. They will remain good until the period for review arrives. Because banks do not want to endanger themselves, they may keep the credit limit low in the first year, until they are satisfied that the customer can repay drafts drawn against the clean letter of credit. In the second year, the bank can raise or lower the limit, and may adjust it thereafter as well.

Companies that use a clean letter of credit in trade must secure the document well. Forged drafts would allow the bank to issue cash to a payee without any supporting information, according to the terms of the letter of credit. Banks typically examine drafts for signs that they are fake or altered in some way, but may not always catch problems, and a snarl can be created while the bank recovers the funds and files charges against the parties involved. During this time, the letter of credit may be temporarily inaccessible.