Documentary Credit Guide: Types, Processes, and Parties Involved
Documentary Credit
Definition
Documentary credit (or letter of credit) ensures payment for goods by aligning payment with goods receipt. The importer pays only when the seller provides documentary proof of shipment according to agreed terms. It’s also known as “payment against documents.”
Parties Involved
- Issuing Bank/Importer’s Bank: Located in the importer’s country, issues the credit based on the importer’s instructions.
- Intermediary Bank/Advising Bank: Verifies the credit’s authenticity and advises the exporter. May also confirm the credit, assuming payment liability.
- Beneficiary/Exporter: Receives the credit amount upon fulfilling the terms.
- Payer/Importer: Applies for the credit and negotiates terms with the exporter.
Issuing Bank Commitment
Revocable
Any party can modify or cancel the credit after issuance. Not recommended for exporters due to lack of commitment.
Irrevocable
Cannot be modified or canceled without all parties’ consent. Ideal for exporting as it provides a firm commitment. Documentary credits are irrevocable unless explicitly stated otherwise.
Advising Bank Commitment
Confirmed
A third-party bank assumes all obligations of the issuing bank, providing an additional layer of security for the exporter.
Unconfirmed
The intermediary bank verifies the credit, advises the exporter, and handles documents. May pay the exporter if authorized by the issuing bank, but doesn’t assume primary payment liability.
Usage
Payment
Exporter receives payment upon submitting compliant documents.
Acceptance
Exporter receives a time draft (bill of exchange) payable at a future date, accepted by the issuing or intermediary bank.
Negotiation
Less common; involves discounting the letter of credit. Recourse against the exporter exists if the issuing or confirming bank fails to pay.
Documentary Credit Process
- Negotiate purchase agreement and credit terms.
- Importer applies for credit issuance.
- Issuing bank assesses risk.
- Intermediary bank advises the exporter of credit opening.
- Exporter ships goods and submits documents.
- Beneficiary collects credit upon document compliance.
- Documents sent to the issuing bank for review.
- Issuing bank pays the importer’s bank, enabling goods release.
Special Documentary Credits
Red Clause (Red Ink Clause)
Allows exporters to receive pre-shipment financing from the importer’s bank.
Green Clause (Green Ink Clause)
Similar to red clause, but the exporter must justify fund usage for export preparation.
Revolving Credit
Automatically renewed upon utilization, suitable for ongoing supply agreements. Can be cumulative or non-cumulative.
Transferable Credits
Allow the first beneficiary to transfer the credit to another party, potentially with modifications to amount, unit prices, and shipment/maturity dates.
Back-to-Back Credits
Used when transferable credits are not suitable. Involves purchasing goods under a documentary credit and selling them to a third party also paid by documentary credit.
Stand-by Letters of Credit
Act as a guarantee, protecting the exporter against importer default. Payment occurs upon presentation of default documentation.
Documentary Collection
A method for exporters to receive payment for shipped goods. The exporter submits documents to their bank, who forwards them to the importer’s bank for collection. Payment or acceptance of a time draft releases the documents to the importer.
Risks
The exporter bears the risk of non-payment or non-acceptance by the importer. In deferred payment sales, the risk is higher as the buyer may accept the goods but fail to pay later.