Legal Definitions - circular letter of credit

A circular letter of credit is a specific type of financial instrument, historically used primarily by travelers, that allows the holder to draw funds from a wide network of banks, rather than being restricted to a single bank or a very limited number of specified banks.

To understand this, it's helpful to first understand a general letter of credit. A letter of credit (LC) is a document issued by a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. If the buyer is unable to make a payment, the bank will cover the full or remaining amount. LCs are commonly used in international trade to reduce risk for both parties.

A circular letter of credit takes this concept of a bank guarantee for funds and extends its flexibility significantly. Instead of naming one specific bank or a small group of banks where funds can be drawn, a circular letter of credit would list numerous correspondent banks across different cities or countries. This meant the holder, typically a traveler, could present the letter at any of these listed banks to receive cash, making it a secure and convenient way to access money while moving through various locations without carrying large sums of physical currency. While less common today due to the prevalence of credit cards and ATMs, the principle highlights broad access to funds through a banking network.

Here are some examples illustrating how a circular letter of credit would function:

• Example 1: The International Business Consultant

  Imagine a business consultant, Ms. Chen, who frequently travels across Asia for client meetings in different cities like Singapore, Hong Kong, and Seoul. Her company wants to ensure she always has access to local currency for incidental expenses, even if her corporate credit card encounters issues or isn't accepted everywhere. They arrange a circular letter of credit through their bank. This letter lists several major banks in each of Ms. Chen's destination cities as correspondent banks. When she arrives in Singapore, she can present the letter at a participating bank to draw Singapore dollars. Later, in Hong Kong, she can do the same to get Hong Kong dollars from a different listed bank, and so on. This provides her with a reliable and flexible way to manage her cash needs across multiple countries.

  How it illustrates the term: This example demonstrates the "circular" aspect by showing Ms. Chen's ability to draw funds from various banks in different geographical locations, all based on a single letter of credit, providing broad access to cash as she travels.

• Example 2: The Gap Year Traveler

  A recent college graduate, Liam, decides to take a gap year backpacking through South America, planning to visit Argentina, Chile, and Peru. His parents are concerned about him carrying large amounts of cash or relying solely on credit cards in unfamiliar places. They secure a circular letter of credit for Liam from their bank. This letter specifies a network of banks in major cities and even some smaller towns across the countries he plans to visit. As Liam travels, he can present his letter at a local branch of a correspondent bank in Buenos Aires to get Argentine Pesos, then later in Santiago for Chilean Pesos, and finally in Cusco for Peruvian Soles. This ensures he has a secure method to access funds throughout his journey, even in areas where ATMs might be scarce or unreliable.

  How it illustrates the term: This scenario highlights the utility of a circular letter of credit for an individual needing flexible access to funds in multiple, diverse locations and currencies, drawing from various banks within a pre-approved network.