What is a Letter of Credit?
A Letter of Credit is a document issued by a bank. It establishes the bank’s guarantee that the buyer’s payment shall be made on time to the sellers. Through a Letter of Credit, the bank takes on the responsibility of making the payment (fully or partially) if the buyer is unable to do so. The buyer is usually a privileged customer of the bank or is accorded the facility against a pledge of securities or bonds. The Letter of Credit is a great facilitator for international trade because it establishes a clear intent and ability to pay, mitigating the risk for the vendors and expediting cross-border trade.
The Hidden Costs of Letters of Credit
The Letter of Credit facility is not free of charge. The bank charges between 0.5% and 2% of the total payment amount as a fee for the facility extended. On large transactions or deals, this amount is a burden to be shouldered by the buyer.
Most financial institutions are not transparent when it comes to disclosing the costs involved with issuing a Letter of Credit. Apart from the fee, there can be between 5 to 10 towards postage, authentication charges, bank-to-bank reimbursement charges etc. These can range from USD 25 to USD 250. Some of these include:
- Amendment Fee – Even the smallest amendment to the Letter of Credit can attract a charge of USD 100-250. Both the buyer’s bank and the vendor’s bank may charge such a fee.
- Transfer fee – The buyer’s bank may charge a fee of up to USD 150 for the payment made to the seller’s account.
- FX spread – The foreign exchange (FX) spread can be quite high and this is a charge that the banks do not reveal upfront.
Understanding the Risks of Letters of Credit
Letters of Credit are among the most commonly used instruments when it comes to international trade. It is estimated that about 11 – 15% of all export transactions across the world are based on Letters of Credit. Despite this,there are several risks and disadvantages involved in using them as an instrument of cross-border credit. These could cause more difficulties and disruption than easing the trade process.
- Sight Credit frauds – A Sight Credit is a Letter of Credit that will be reimbursed or paid for upon presentation. This means that the bank will not verify the authenticity of the holder and will pay to anyone who presents the Letter of Credit. This exposes the buyer and the vendor to fraud risks. If the Letter of Credit is lost or misplaced or stolen, the payment may not reach the intended payee.
- Issues with Usance Bills – Usance Bills are Letters of Credit offering time credit. This means that they are payable after a particular date. A vendor may be issued a Letter of Credit offering payment about 15 days after the date of delivery. Now after the goods are delivered, the vendor may have to wait 15 days to receive the payment. This time-lapse could cause issues with working capital and with accounting.
- Risks involved in Revocable Letters of Credit – A Revocable Letter of Credit is a payment guarantee but the terms and conditions of the payment may be altered or even cancelled by the bank without any prior intimation to be the payee. This is a risk that the vendor bears when he/she accepts a Revocable Letter of Credit.
Escrow Service – A Viable Alternative
Online escrow services offered by platforms such as Tazapay are emerging as a viable alternative to Letters of Credit. How escrow is calculated also makes it a much more cost effective alternative. The terms of the transaction and trade deal are settled by the buyer and the vendor and they settle on a reliable escrow service provider. Escrow services are backed by the guarantee of recognized regulators. Tazapay, for example, is specifically designed to facilitate international trade and their payment facilitator Rapyd is regulated by the Monetary Authority of Singapore (MAS).
By depositing the amount negotiated into a specific escrow account, the buyer makes clear their intent and ability to buy. Once the transaction is completed by the seller and proof of dispatch is furnished, the third-party escrow service provider transfers the payment to the seller. In most cases, the payment arrives in the seller’s bank account within 1-2 business days.
The greatest advantage of using an escrow account is that the service provider only charges an escrow fee of 1.8% of the transaction amount and is capped at USD 250. This fee can be paid by the buyer or seller or split between the parties.
The best part is that there are no other hidden charges. Amendments can be made for free. Buyer and seller have full transparency of fees upfront.