Letters of credit (LC) provide financial guarantees that reduce risk and enable financial transactions between often distant parties. A seller might otherwise be unwilling to send goods before being paid; a buyer may not want to send money until he's received the goods.
Letters of credit are either commercial or standby. The commercial LC is a primary payment mechanism, a form of commercial paper that functions as currency. A standby LC is a secondary payment mechanism, used only when the primary payment mechanism fails. It functions as a strictly binding guarantee. Fees for both kinds of LCs vary, depending on perceived risk, demand, length of LC contract to expiration, whether or not the LC is revocable and many other factors.
The fees required for LCs will depend on a variety of factors, including the risk associated with the contract, as well as the specific type of LC needed.
Defining Fees for Commercial LCs
A typical commercial LC transaction has more than one fee and provides a guarantee for a limited time, often four months. Some fees are assumed by the seller, others by the buyer. One LC management company proposes that for LCs in excess of $100,000, a typical buyer's fee is 0.75 percent, but notes that in underdeveloped countries, it can range from 1.5 percent upward.
The seller's total fees will probably be less, but there will be 5 to 10 different charges, each ranging from $25 to $150, for postage, courier services, bank-to-bank reimbursement charges, authenticating the LC and other services.
Exploring What the Fee Covers
When a bank issues an LC on behalf of a customer, it authorizes another bank -- known as the advising bank -- to pay a specified amount of money to a named beneficiary. The beneficiary usually provides goods or services to the issuing bank's customer. This facilitates transactions between parties that are often not well-known to one another and in different countries.
Each party's bank relies on a shared confidence in the banking system, their familiarity with their own customer -- and in some instances other guarantees -- to carry out the transaction. LCs, unless they are specifically revocable in the original documents, cannot be canceled once issued.
Evaluating Fees for Standby LCs
Fees for standby LCs also vary, but typically range higher -- from 2 to 3 percent per year. Standby LCs can be in any amount, but most range from $250,000 upward. In a typical standby LC transaction, the purchaser of the LC obtains the LC from a bank, which issues the standby LC to the beneficiary company, guaranteeing that in the event the investor fails to make one or more payments according to the terms of a contract, the issuing bank will make the payment to the company on the investor's behalf.
Standby LCs have fewer ancillary fees, require less rigorous documentation and may renew over a period of years. The standby LC has a seldom-invoked fraud exception to the general rule that once issued, an L/C cannot be canceled.
Assessing LC Guarantees
Standby LCs provide strong guarantees that the holder will be paid in the event that the buyer of the LC fails to pay according to a contract. Once issued, the LC can seldom be canceled. This gives the holder assurance that he can rely on money not yet received.
Usually, the buyer provides the bank an assurance that in the event he fails to fulfill the agreement and the bank pays on his behalf, the bank will be compensated. One arrangement, for instance, provides for the buyer to sign over provisional title to an asset, such as an equity account. If he defaults, the bank pays the beneficiary, assumes title and liquidates the account.
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