Red Clause Letter of Credit

A red clause letter of credit is a letter of credit containing a clause that authorizes a bank in the exporter's country, usually the advising or nominated bank, to pay the beneficiary an advance before shipment. The advance is typically made against a simple receipt and a written undertaking from the beneficiary to ship and to present the required documents. When the shipping documents are later presented, the advance plus interest is deducted from the amount paid.

The clause is a form of buyer-funded pre-shipment finance: the importer, through its issuing bank, bears the risk that the exporter takes the money and never ships. UCP 600 does not deal with red clauses specifically, so the exact terms come from the wording of the credit. Its closest relative is the green clause letter of credit, which adds a requirement that the goods be held in a warehouse as security.

Imagine hiring a builder who needs cash for bricks before starting work. Instead of paying the builder directly, you tell your bank to let the builder's local bank hand over part of the price upfront. When the job is finished and inspected, the builder gets the rest, minus what was already advanced. If the builder disappears, your bank repays the local bank and then asks you for the money.

That is the red clause idea. The overseas buyer trusts the seller enough to fund its purchases of raw materials, but wants a bank to handle the cash and the paperwork. The seller gets working money early. The buyer takes the risk that the goods never arrive, which is why the clause is used mainly between parties who already know each other well.

The name comes from the practice of printing or typing the advance clause in red ink so that it stood out from the standard terms. The structure is traditionally linked with the Australian and New Zealand wool trade, where buying agents needed cash to purchase wool at auction before it could be baled and shipped to buyers in Britain. It later spread to other seasonal, agricultural trades such as cotton, fish and hides. Today the clause is rarely printed in red; the term simply describes the advance feature.

1. The importer applies for a credit containing the red clause, stating the amount or percentage that may be advanced (often 20 to 50 percent of the credit value) and the documents needed for the advance.
2. The advising bank pays the advance to the exporter against its receipt and undertaking. Some red clauses require the exporter's bank to issue an advance payment guarantee or standby credit back to the importer, which shifts some of the risk.
3. The exporter uses the money to buy raw materials or pay producers, then ships and presents the full set of documents.
4. The paying bank deducts the advance and accrued interest from the proceeds and remits the balance. If the exporter never ships, the advancing bank claims repayment from the issuing bank, which debits the importer.

Interest on the advance is usually for the account of the beneficiary and is often quoted as a margin over a reference rate such as SOFR for US dollar credits.

Red clauses suit exporters that are small, seasonal or short of bank credit, such as farm cooperatives and SMEs, and buyers who want to lock in supply from them. A buyer may accept the risk because a sure supply of produce at harvest time is worth more to it than the cost of the occasional loss. For the exporter, a red clause is often cheaper and faster than its own bank's packing credit, because the credit decision rests on the importer and its bank.

The weakness is that the advance is unsecured. Nothing stops the exporter from using the money for something else. Buyers manage this by limiting the percentage advanced, splitting it into tranches, or moving to a green clause, where the money is released against warehouse receipts for goods already bought.

Because cash moves before any goods exist, banks look closely at red clause credits for trade-based money laundering: a credit that is advanced but never shipped against can be a way to move funds under cover of trade. Banks check that the advance is in line with the business of the exporter and that shipments eventually follow. Alternatives that achieve a similar result include cash in advance backed by a guarantee, purchase order financing from a specialist lender, or ordinary pre-shipment loans from the exporter's own bank.

• International Chamber of Commerce