A Primer on Letters of Credit (LCs)
Mohamad Haj Hasan
What is an LC?
An LC is a critical part of doing business between countries. It is set up as a buffer of trust in thebanking system that allows two counterparties to trade goods in return for payment in such away that guarantees the rights of both parties. An LC is essentially a guarantee from the buyer’sbank to the seller’s bank that they will pay a specific amount money in exchange for goods. Inreturn for this guarantee (or confirmation), the bank’s involved take a fee from the buyer (andsometimes from the seller) as well as a certain percentage of collateral insurance against thetotal amount from the buyer.The steps and fees involved in opening an LC are as follows:1. Buyer goes to their local bank and requests to open an LC. The buyer communicates totheir bank the following information:a. The amount of the LC (i.e. total price for the goods).b. The country where the seller is located in.c. The bank that the seller deals with in that country.d. The time period that the LC should be opened for.e. The payment terms for the LC. The buyer can either request a site LC (whichmeans that the seller gets paid immediately upon submission of certaindocuments) or a deferred LC (which means that the seller gets paid after acertain period of time upon submission of certain documents).2. The bank studies the buyer’s request and communicates the following information to thebuyer:a. The LC fees per period (in percentage terms of the total amount per 3-monthperiod).b. The collateral that the buyer must put up as a percentage of the total amount of the LC.c. If the bank does not have a local branch in the seller’s country, the bankcommunicates to the buyer the confirmation fees between them and the seller’slocal bank in the foreign country. The confirmation fees are essentially guaranteefees that the foreign bank charges the buyer’s local bank in order to process theLC, and the buyer’s local bank reflects these charges back onto the buyer.d. The reconfirmation fees between the buyer’s local bank branch in the seller’scountry and the seller’s local bank (if they are different). These reconfirmationfees are essentially guarantee fees that the seller’s bank charges the buyer’slocal bank branch in order to process the LC. The seller, and not the buyer, paysfor these fees in most cases.