Most Asked Questions on Letter of Credit

In international trade and business dealings, a Letter of Credit is a trusted way of mitigating the risk for vendors. Its universal acceptance amongst business-conducting parties comes from the ease with which it established a clear intent and ability to pay. Its importance can be gauged from the fact that the global letter of credit confirmation market is projected to reach a value of $4.99 billion by 2027.

Yet, the term can be confusing for many people, especially those who are exploring secure means of payment for the first time. This article aims to clarify some of the common FAQs you have regarding letter of credit and related queries.

What is a Letter of Credit?

Letters of credit are legal documents issued by the buyer's bank for the benefit of the exporter and are intended to assure the seller that the buyer will pay them in full for the goods and services delivered. If any buyer cannot comply with the terms and conditions of a contract, fails to pay a certain amount in an ongoing trade transaction, or is unable to pay, the issuing bank will pay the exporter instead. You can say that it is a safe and secure agreement between the buyer and seller to guarantee payment of the purchase price.

How does a Letter of Credit work?

• To obtain a documentary credit (LC), the applicant or buyer/importer must approach the issuing bank.
• Advisory banks (exporter's banks) receive the letter of credit from the issuing banks and forward it to the sellers after verifying the authenticity of the letter of credit.
• In addition to the bill of lading provided as proof of the shipped goods, the seller also sends the goods as per the details in the contract.
• It is now the seller's turn to present the bill of lading to the nominated or negotiating bank. Banks pay sellers after checking whether they delivered goods following specifications.
• The negotiating bank now sends the shipping documents to the issuing bank to release the payment.
• When shipping documents are sent to the buyer, the issuing bank verifies the information and requests approval.
• The buyer pays the issuing bank, and the bank forwards the amount to the negotiating bank.

How do letters of credit benefit a company?

A letter of credit comes with a wide range of benefits, including the following:

• For the buyer, it serves as a credit certificate
• Ensures payment to the seller on time
• Expansion of overseas business on a secure platform
• Depending on the parties' needs, it can be customized
• Increases risk for the issuing bank instead of the buyer
• The seller receives payment for fulfilling terms
• A legal guarantor guarantees the amount

What is the difference between a Letter of Credit and a bank guarantee?

In essence, both a letter of credit and a bank guarantee act as insurance against credit risk involved in transactions between two parties. Both letter of credit and bank guarantee step in to enable the buyer to make the payment in full or part as per the contractual obligation in case he/she is unable to do so. However, a letter of credit is often used by import and export companies, whereas a bank guarantee is used by contractors in infrastructure projects. Additionally, while a letter of credit ensures that a transaction is fulfilled, a bank guarantee serves to reduce any losses in the event of transaction failure.

Are there any fees associated with letters of credit?

Banks may charge different amounts or interest rates for a letter of credit based on the type, size, volume, or nature of the business, the relationship between the bank and buyer, and the quantity and type of goods.

What is the timeframe for receiving a letter of credit?

The time it takes to receive a bank letter of credit depends on the issuing bank providing the loan. Getting approval from the bank typically takes about 10-15 working days. However, this can be extended by another few days in some cases.

How much does it cost to issue a letter of credit?

The lenders generally charge 2% along with documentation fees, which the borrower must pay at closing. Standby LC fees are 2.5% if the loan amount is less than $50,000.

Are there any hidden costs associated with letter of credit?

Yes, you need to be aware of multiple hidden costs when it comes to obtaining a letter of credit. These include:

• Amendment fee of up to $150 for both buyers and sellers if they want to change the agreement
• Transfer fee of up to $150 for any payment made from buyer to seller
• A possibly high Foreign Exchange Spread which the bank could apply without notifying the buyer upfront  

Letters of credit are subject to what types of risks?

While letters of credit do have their advantages, they are not without risks, especially fraud. Some of these include:

• Sight Credit fraud: The bank will make the payment to anyone who presents the letter of credit to them without verification, making misplaced, lost or stolen LCs a risky proposition.
• Revocable letters of credit: This type of letter of credit is subject to terms and conditions that can be altered by the issuing bank anytime. Hence, there could be an instance where the bank refuses to pay.
• Usance bills: These letters of credit are payable only after a particular date, which can put the vendor at risk due to issues with working capital and accounting.

A Letter of Credit is surely a viable payment instrument that can remove your credit risk. But it is also not without its fair share of disadvantages. As an alternative, you can always consider online escrow services offered by platforms like Omoney.

Escrow is a modern-day alternative to letter of credit and eradicates all the risks involved. It is a cost-effective solution because of how transparent and simplified it is. Typically, the transaction terms are decided between the buyer and the vendor, and they choose an escrow provider who will serve as an escrow agent.

Most importantly, renowned regulatory agencies back escrow services, such as Singapore’s Monetary Authority of Singapore (MAS) regulates Omoney. Additionally, there are no hidden costs and you only need to pay 1.8% of the transaction amount. Moreover, online escrow services also provide you with vendor/buyer verification so that you know that you are engaging in a transaction with a trusted party.