Understanding Documentary Credit for International Business

A documentary credit is a type of letter of credit that's commonly used in international business transactions. It's a payment guarantee issued by a bank on behalf of the buyer.

The documentary credit is typically issued in favor of the seller, who can then use it to verify the buyer's payment obligation. This provides a level of security and trust in the transaction.

The documentary credit is usually issued in the form of a letter, which outlines the terms and conditions of the sale, including the price, quantity, and delivery date. The letter also specifies the documents required to be presented by the seller to the bank to receive payment.

The seller must present the required documents to the bank, which then verifies their authenticity before releasing the payment to the seller. This process helps to prevent fraud and ensures that the buyer's payment obligation is fulfilled.

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A documentary credit is a type of irrevocable credit issued by a bank in favor of a seller. This credit is paid against the tender of shipping documents.

The buyer typically procures their bank to issue this credit. The bank undertakes to pay an agreed sum of money to the seller.

In an international sales contract, the buyer usually has the duty to issue this credit. The credit is issued in favor of the seller by the buyer's bank.

The type of documentary credit issued is distinct from another form of letter of credit. This other form is issued by a bank in favor of its own customer.

The documentary credit is issued by the buyer's bank at their request. The credit is in favor of the seller, who must tender shipping documents to receive payment.

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Documentary credits come in several types, each with its own set of characteristics and benefits. One of the most common types is the revocable documentary credit, which can be modified or cancelled at any time by the importer without the exporter's agreement.

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A revocable documentary credit is not commonly used due to the high risk it poses to the exporter. If the credit is cancelled, the exporter will be left with a large quantity of goods that may not be sold, resulting in significant losses.

Irrevocable documentary credits, on the other hand, provide a higher level of security for the exporter. With this type of credit, the importer's bank cannot modify or cancel its payment commitment unless the parties come to an agreement.

Here are the main types of documentary credits:

Irrevocable and confirmed documentary credits offer the highest level of security for the exporter, as they contain a guarantee from the participating banks. This type of credit is ideal for international trade, as it covers business risks and provides a high level of security for the exporter.

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Irrevocable documentary credits are considered firm commitments to pay, as the importer's bank cannot modify or cancel its payment commitment unless the parties come to an agreement. This type of credit makes a firm commitment to pay, and the exporter considers it as an order confirmation.

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In theory, an irrevocable documentary credit is automatically irrevocable with the UCP 600 agreements, which means it cannot be modified or cancelled. This provides a high degree of security for the exporter.

Revocable documentary credits, on the other hand, can be modified or cancelled at any time by the importer without the exporter's agreement. The importer's bank also has the right to cancel its commitment before shipment of the goods.

The concept of revocability no longer exists in the ICC rules covering documentary credits – the UCP 600. However, if a revocable credit is to be issued, the terms of the revocability are to be incorporated into the credit.

Banks are unlikely to ever confirm a revocable credit, as it does not provide any satisfactory degree of security for the exporter.

Here's a quick rundown of the key differences between irrevocable and revocable documentary credits:

A documentary credit can be a bit like a gift card - it can be transferred to someone else. This type of credit is called transferable.

The credit must clearly state that it is transferable for this to be effective. Any transfers must be made on the same terms and conditions as the original credit.

The bank is not obligated to transfer a credit unless they agree to do so. If they do transfer it, the first beneficiary is usually responsible for paying any charges incurred during the transfer.

A credit can be transferred in part to multiple second beneficiaries, but only if partial drawings or shipments are allowed. Once a credit is transferred, it cannot be transferred again at the request of a second beneficiary to a subsequent beneficiary.

The percentage for which insurance cover must be effected may be increased to match the amount of cover stipulated in the credit. The name of the first beneficiary can be substituted for that of the applicant in the credit, but only if the applicant's name is required in certain documents, such as an invoice.

Here are some key points to keep in mind when it comes to transferable credits:

There are several types of documentary credits, each with its own unique features and benefits.

Revocable documentary credit can be modified or cancelled at any time by the importer without the exporter's agreement. This type of credit is almost never used due to the high risk for the exporter, who may be left with unsold goods if the credit is cancelled.

Irrevocable documentary credit, on the other hand, makes a firm commitment to pay, providing the exporter with a high level of security.

Irrevocable and confirmed documentary credit offers even more security, with a guarantee from the participating banks. This type of credit provides optimal security for the seller by covering business risks.

Irrevocable and notified documentary credit is similar to the confirmed type, but without the guarantee of the confirming bank. This type of credit increases the risk for the seller, especially in countries with unstable political or economic contexts.

A confirming bank is usually the correspondent of the importer's bank located in the exporter's country, and assumes the credit risk of the issuing bank in addition to the political or transfer risk of the importer's country.

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Documentary credit involves several key features and terms that are essential to understand.

There are three main types of documentary credit: red clause credit, revolving credit, and back to back credit.

Red clause credit allows the seller's bank to grant an advance to the beneficiary, who must then present the required documents.

Revolving credit automatically renews the terms of the documentary credit after each use by the beneficiary.

This type of credit is ideal for frequent deliveries without jeopardizing the issuing bank's commitment.

Back to back credit enables third parties to benefit from the credit via a transfer, which can be useful when a supplier uses an intermediary.

The incoterm used is also an important consideration in documentary credit.

Here are the three main types of documentary credit, summarized:

Confirmation is a definite undertaking of the confirming bank to honour or negotiate a complying presentation, and is usually requested by the beneficiary at the time of agreeing the sale of goods.

A beneficiary may request confirmation due to concerns with the risk of the issuing bank, country risk, or documentary risk.

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A letter of credit is essentially an escrow account that guarantees payment to the seller when the buyer performs specific acts or meets performance criteria outlined in the agreement. This is similar to an escrow account, where payment is only released when certain conditions are met.

The International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions. This ensures a standardized process for international trade.

Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. This ensures that the buyer has the necessary assets to cover the payment.

Payment times may vary depending on the terms and conditions of the documentary credit. For example, payment at sight can be made as soon as the documents have been validated, while payment against acceptance establishes a payment with a deadline.

Here are some common types of documentary credit payment terms:

A letter of credit is a guarantee of payment issued by a bank, essentially assuming the responsibility of ensuring the seller is paid. It's like an escrow account where payment only happens when the other party performs a specific act or meets other performance criteria spelled out in the letter of credit agreement.

To get a letter of credit, a buyer must prove to the bank that they have enough assets or a sufficient line of credit to pay before the bank will guarantee the payment to the seller. This is usually done by providing a pledge of securities or cash as collateral.

The bank will charge a fee for issuing a letter of credit, typically a percentage of the letter of credit, and the buyer will also be required to pay this fee. The fee is usually a percentage of the letter of credit, and the bank will charge it to the buyer.

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Letters of credit can be transferable, meaning the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw. However, this is not always the case, and it depends on the specific terms of the letter of credit agreement.

Here are the different types of letters of credit:

Each type of letter of credit has its own specific characteristics and requirements, and it's essential to understand these before using one in a transaction.

The cost of documentary credit can vary depending on the level of guarantee. It's usually calculated by the notifying bank or the confirming bank.

Fees charged by the issuing bank can range from 0.5% to 3% per year, with front end fees around 1% per year, payable quarterly. Usage fees are typically around 0.25% per quarter.

Risk fees are also charged by the issuing bank, around 0.25% per quarter. Instalment fees can be around 0.08% per month until the expiration.

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Notification fees charged by the notifying bank are 0.1% per year for documentary credit in amounts below about 1.2 million Euros. Confirmation fees vary with the degree of risk, generally around 0.2% per quarter.

Document collection fees can be 0.15%, and payment, acceptance and negotiation fees are about 0.15%. The parties involved may decide beforehand who pays the costs of the transaction.

It's customary for the buyer to pay the fees of the issuing bank in its country, while the seller bears the fees of the second bank.

Letters of credit can be obtained within two business days, guaranteeing payment by the confirming bank. This is especially valuable for clients in unstable economic environments.

To apply for a letter of credit, it's best to have a trained professional prepare the documents, as mistakes can lead to payment delays and fees. Industry variations and types of letters of credit require a customized approach.

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Here's a step-by-step example of how to apply for a letter of credit:

An example of a letter of credit is provided by Citibank, which offers this service to buyers in regions like Latin America, Africa, Eastern Europe, Asia, and the Middle East.

Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch.

This benefit is especially valuable when a client is located in a potentially unstable economic environment, such as those found in some of the regions mentioned.

Applying for a Letter of Credit is a multi-step process. Letters of Credit are best prepared by trained professionals to avoid mistakes that can lead to payment delays and fees.

To start, the importer's bank credit must satisfy the exporter and their bank. This is typically done through a sales agreement that outlines the terms and conditions of the transaction.

A sales agreement is necessary to draft the letter of credit, which is then sent to the exporter's bank for review. The exporter's bank will send the letter of credit to the exporter after approval.

The exporter must ship the goods as described in the letter of credit, along with any required documentation. This documentation is submitted to the exporter's bank for review.

Here's a step-by-step breakdown of the process:

By following these steps, you can successfully apply for a Letter of Credit and ensure a smooth transaction.