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A Primer on Letters of Credit (LCs)

A Primer on Letters of Credit (LCs)

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Published by Mohamad Haj Hasan

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Published by: Mohamad Haj Hasan on Oct 21, 2008
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04/14/2014

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A Primer on Letters of Credit (LCs)
Mohamad Haj Hasan
 
1 |Page 
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.
 
A Primer on Letters of Credit (LCs)
Mohamad Haj Hasan
 
2 |Page 3. The buyer negotiates the LC terms with their bank and agrees to move forward, in whichcase the LC is issued to the seller’s local bank.4. The seller ships the goods to the buyer, and gives their local bank the following papers:a. A legalized invoice for the goods (legalized by their local Chamber of Commerce).b. Approximately four copies of the original clean Bill Of Lading (BOL), which isproof that the goods are on the ship and in good condition.c. A legalized certificate of origin (legalized by their local Chamber of Commerce).5. The local bank credits the account of the seller (if the LC is a site LC) and requestspayment from the local bank of the buyer. They in turn send the paperwork to the localbank of the buyer upon receipt of payment and the local bank of the buyer requestspayment for the goods from the buyer. Upon successful payment, the local bank sendsthe buyer the original paperwork for the goods so that they can clear the goods fromcustoms when they arrive at the destination port.
 
A Primer on Letters of Credit (LCs)
Mohamad Haj Hasan
 
3 |Page 
Figure 1.
How a Site LC Works

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