Documentary credit is the most widely used payment method in international trade. It is therefore particularly important for trade professionals. What is documentary credit? How does it work? Who are the main players involved in a documentary credit process? Discover the main advantages and drawbacks of documentary credit in this article.
Documentary credit (or letter of credit) is a method of payment that facilitates and secures international transactions. In practical terms, a bank undertakes, on behalf of its client (the importer), to pay a beneficiary (the exporter) the price of goods or services within a specified time. In return, the exporter sends a remittance of previously agreed upon and approved documents proving the value and shipment of the goods or services.
Documentary credit is used for very high transaction amounts or when one party has doubts about the honesty or solvency of the other. This way, international transactions are secured and both the exporter and the importer have a guarantee.
Note that: The documentary credit system is a separate transaction from the sale of goods and the shipping contract.
The reliability of documentary credit and its use on an international scale has made it the most widely used B2B payment method in France. Created to secure international business transactions, it is especially designed for:
● Companies trading with so-called "at risk" countries or with new customers;
● Companies exporting made-to-order products;
● Companies that do not have credit insurance agreements to cover their export customers. Thus, documentary credit offers a high level of guarantees with participating banks. For the importer, it ensures that payment is only made if the seller fulfils its contractual obligations. For the exporter, it ensures that payment will be made on time.
Note that: The efficiency of the payment process depends both on the reliability of the banks and compliance with the official procedures. Before a documentary credit is opened, instructions must be clearly detailed and followed to the letter at each step in the process.
Generally, four main players are involved in a documentary credit process: The importer (the purchasing customer), its bank (the issuing bank), the exporter (the seller) and its bank (the notifying bank). A fifth party may also sometimes be solicited: A confirming bank.
- The Instructing Party: As the purchasing customer, this party initiates the documentary credit process. It is also the importer’s responsibility to give instructions for the opening of the documentary credit.
- The Issuing Bank: This bank opens the documentary credit at the importer’s request. In the majority of cases, it is located in the buyer’s country and opens the documentary credit.
- The Notifying Bank (the seller’s bank): This bank communicates with the issuing bank (the buyer’s bank) and informs the beneficiary of the documentary credit process. It is usually located in the seller’s country but does not make any payment commitment to the seller. It may be the confirming bank if it confirms the documentary credit.
- The Seller (or exporter) is the final beneficiary of the payment (the payee). The documentary credit is opened in its favour.
- The Confirming Bank: Sometimes a third bank may intervene in the documentary credit process: the confirming bank. Solicited by the issuing bank, its role is to guarantee the beneficiary’s payment, i.e. to the seller. The exporter has the possibility of specifying this guarantee in the contract of sale to reassure the buyer. This way, if one of the parties is located in a country in which there are foreign exchange restrictions for example, the exporter will have more confidence in the transaction. By going through financial institutions as trusted third parties, the parties transfer the risk of potential disputes to neutral partners.
In the context of international trade, documentary credit remains the safest procedure to guarantee smooth business transactions for both buyers and sellers.
An excellent payment method Quick, efficient and above all recognised worldwide, documentary credit can be used in nearly all international transactions. It is subject to the Uniform Customs and Practice for Documentary Credits (UCP) rules governed by the International Chamber of Commerce (ICC). This process is therefore both a means of covering certain risks for the seller and an advantageous financing method for the buyer.
Bank security by commitment A true guarantee of security, documentary credit offers the advantage of ensuring the buyer that it will only pay if the documents are compliant with the terms and conditions of the credit and the UCP. Conversely, the exporter benefits from a maximum payment guarantee for the sale of goods, especially in the case of a confirmed documentary credit.
The documentary credit process may put some companies off using it. But rest assured, by following the steps below you have every chance of the process going smoothly.
1. Signing of the contract between the Exporter and the Importer
A crucial step for opening a documentary credit is the signing of the contract, which initiates the process. The two parties agree to the terms and conditions of the transaction in a contract duly completed and signed. The contract contains:
● The goods;
● The shipping and carriage conditions;
● The delivery times;
● The documentation to be provided by the buyer;
● The type of payment (in this case, the documentary credit);
● The method of payment; the course of action in case of a dispute (non-payment, problems with goods, etc.).
It is highly advisable to consult international trade professionals to avoid certain pitfalls and set up a fair deal for all the parties involved. Documentary credit forms are available online. Be sure to fill out all of the required information: The omission of any important information could jeopardise the entire process.
At the same time, the two parties must contact their respective banks during this initial phase of the process and not after the signing of the contract. Corporate banks are often familiar with documentary credit and are able to give helpful advice to successfully carry out the transaction in legal, logistical and financial terms.
2. Request for the Opening of a Documentary Credit
The importer asks its bank to open a documentary credit of which the exporter is the beneficiary. Banks have a number of forms that the importer must complete and sign in order to formalize the request. In certain cases, a letter of request may suffice. Even though the documentary credit may make reference to the contract of sale, it is important to note that the bank is not bound by the terms and conditions of that contract. It must only follow the instructions given by the client in the request form and nothing else.
After receiving the request, the bank will do a thorough check of the client’s situation. Otherwise, it may ask the client to pay a deposit for the opening of the credit or grant them a payment term on their usual line of credit. One important point to note is that approval of a documentary credit is not automatic. The bank may consider the transaction to be too risky and reject the request.
3. Issuing of the Documentary Credit
The importer’s bank issues the documentary credit in compliance with the request received from its client. For cases of irrevocable credit, the bank can no longer withdraw as from this stage. It therefore undertakes to pay the beneficiary in exchange for the remittance of the documents listed in the documentary credit.
4. Notice of Confirmation or Rejection of the Documentary Credit
After receiving the documentary credit, the importer’s bank correspondent can add its confirmation. This proof of commitment from the issuing bank means that it will make the payment in the manner defined in the documentary credit. In other words, the exporter’s bank becomes the correspondent for the importer’s bank (with some exceptions).
Whether there is confirmation or not, the correspondent notifies the exporter that a documentary credit has been opened in its favour. It must send the exporter the original in printed paper format.
5. Shipping of Goods
The seller ships the goods as agreed in the contract. It receives from the carrier a certificate of acceptance and proof of shipment. The transaction may relate to goods such as:
● Consumer goods;
● Goods needed in the manufacturing of a finished product;
● Industrial machinery.
● The conditions and delivery times of shipment depend on the type of goods.
Consequently, it is important to clarify the responsibilities between the parties. The International Chamber of Commerce has therefore created the Incoterms. They are international rules that facilitate communication and clearly define responsibilities between the parties to the international transaction.
6. Remittance of Documents
Once the goods have been shipped, the exporter gathers all of the documents listed in the contract and gives them to its bank. These are particularly trade documents, technical documents, transport documents and financial documents. (See details below in the article). All of the documents set out in the request to open the credit must be given to the bank. Otherwise, the exporter risks not being paid due to non-compliance.
7. Sending of the Documents
Upon receiving the documents, the notifying bank checks that they are compliant. They must match the documents listed in the opening of the documentary credit. The notifying bank is not responsible for checking their authenticity. If it notices a missing document, it agrees to inform its client, the exporter. Once the documents are completed, the bank sends them to the importer’s bank by post.
8. Payment by the Issuing Bank
It is then for the issuing bank (the importer’s bank) to carry out a verification process. To transfer the funds, it must respect the payment deadlines defined in the terms and conditions. This can be a payment at sight, a deferred payment or a negotiated payment. (See below)
9. Payment to the Exporter by the Notifying Bank
The funds are made available to the exporter by its bank after it receives payment from the issuing bank. Whether the payment is at sight, deferred or by acceptance, the notifying bank will only pay the customer after receiving the funds.
10. Remittance of Documents
The importer’s bank sends the completed documents to its client. Once these documents are received, the client may take possession of the goods and obtain customs clearance.
11. Repayment by the Buyer
The final step in the documentary credit process, the payment made by the importer, varies depending on whether or not it is able to make immediate payment. The importer can immediately repay the sums transferred by its bank to the exporter.
However, in the majority of cases, the buyer has incurred too many expenses for the payment and customs clearance of the goods. It is therefore rarely capable of making repayment upon receiving the documents. In addition to the documentary credit, its bank generally offers a loan that it reimburses with the profit earned on the sale of its goods.
As the pillars of a documentary credit, banks require several documents that must comply with the terms and conditions of the credit. These include, in particular:
● Trade documents: invoice, packing list, certificate of origin;
● Technical documents: certificates of analysis, health or phytosanitary certificates issued by public authorities; monitoring, control and quality certificates issued by specialised companies;
● Shipping documents: bill of lading, air or sea waybill;
● Financial documents: IBAN, BIC, account history, payment method.
There are a number of types of documentary credit. The main types of documentary credit are revocable and irrevocable, notified or confirmed.
Revocable Documentary Credit Revocable documentary credit 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. No formal legal relationship is established between the seller and the buyer’s bank. The higher the sums involved, the greater the risk for the exporter. This is because, in the event of cancellation or withdrawal of the customer or its bank, the exporter will be left with its volume of goods unshipped. This lack of guarantee partly explains why this type of documentary credit is almost never used.
Irrevocable Documentary Credit With irrevocable credit, the importer’s bank cannot modify or cancel its payment commitment unless the parties come to an agreement. In theory, it therefore makes a firm commitment to pay. As a result, the exporter considers the irrevocable documentary credit as an order confirmation. It can begin its production of the goods as it is sure to be paid by the importer’s bank provided that it fulfils its commitments.
Note that: The documentary credit is however, automatically irrevocable with the UCP 600 agreements (Uniform Customs and Practice).
Irrevocable and Confirmed Documentary Credit Irrevocable and confirmed documentary credit contains a guarantee from the various participating banks (issuing bank, notifying bank and confirming bank, if applicable). Payment can be made to the seller if the documentary credit terms and conditions are fulfilled.
In the event of a request for confirmation, this must be expressly mentioned by the importer. This confirming bank is an additional guarantee to confirm the conformity of the documents in the documentary credit process. Moreover, it is the bank that assumes the credit risk of the issuing bank in addition to the political or transfer risk of the importer's country. The confirming bank is usually the correspondent of the importer’s bank located in the exporter’s country. Without confirmation of the documentary credit, the notifying bank merely forwards it to the beneficiary without making its own commitment.
This type of documentary credit offers the seller optimal security by covering the business risks.
Irrevocable and Notified Documentary Credit Notifying a documentary credit means informing the beneficiary (the exporter) that it has been issued in its favour. This notification is given by a single bank called the notifying bank. This is usually the exporter's bank, located in the same country. When the documentary credit is notified, only the importer’s bank has committed to pay. The notifying bank credits the exporter’s account after receiving the funds from the importer’s bank.
With irrevocable and notified credit, the risk increases depending on the political or economic context in the country of export. In the event of force majeure (political unrest, economic or social crisis, etc.), the seller's bank does not guarantee the payment.
Find the full fact sheet on foreign exchange risk management:
There are three main terms for issuing documentary credit: red clause credit, revolving credit, and back to back credit.
Red Clause Credit By opting for a red clause credit, the seller's bank can grant it an advance. It includes a special clause authorising the notifying or confirming bank to pay an advance to the beneficiary, in return for its undertaking to carry out the shipment and to then present the required documents. This clause, inserted into the request from the instructing party, specifies the authorised amount of the advance.
Revolving Credit With revolving credit, the terms of the documentary credit are automatically renewable. The amount is automatically renewed after each use by the beneficiary until its expiration. It is therefore possible to respect the frequency of deliveries without jeopardising the irrevocable commitment of the issuing bank on the contract. This is why the credit is said to be revolving in amount or in duration.
Back to Back Credit Finally, back to back credit allows third parties to benefit from the credit via a transfer. This can be important if a supplier uses an intermediary between the exporter and the importer. In this case, the initial beneficiary of the credit (the exporter) asks its bank to open a line of credit for its own supplier. This is referred to as a credit that is "backed" to the first one opened in its favour.
Depending on the terms and conditions defined at the opening of the documentary credit, payment times may be longer or shorter.
Payable at Sight Payment at sight is a very simple process and can be done as soon as the documents have been validated.
Payment against Acceptance In the same way as a deferred payment, a documentary credit with payment against acceptance establishes a payment with a deadline. The exporter obtains an accepted bill from the notifying or confirming bank. Sometimes, this can come from the issuing bank. Thus, acceptance is a guarantee of payment on the due date.
Negotiation Negotiated payment terms may be:
● At sight;
● A time payment to any bank in the exporter's country (open negotiation);
● To a single bank again in the exporter's country (restricted negotiation). The negotiating bank may discount the documents by paying an advance to the exporter with a deduction of charges. For a notified credit, this advance is paid under usual reserve; for a confirmed credit, firm and final negotiation is called non-recourse.
The cost of documentary credit varies mainly with the level of guarantee. Therefore, revocable credit is less expensive than irrevocable and confirmed credit.
The costs of the documentary credit are calculated by the notifying bank (in other words, the exporter's bank) or the confirming bank. The main factor in costs relates to the risk involved: the riskier the transaction, the more expensive it will be. Costs of documentary credit vary between 0.5% and 3% per year.
Here are the different costs of a documentary credit in detail:
1. Fees charged by the issuing bank
● Front end fees: around 1% per year, most often payable quarterly;
● Usage fees: around 0.25% per quarter;
● Risk fees: around 0.25% per quarter;
● Instalment fees: around 0.08% per month, until the expiration.
2. Fees charged by the notifying bank
● Notification fees: 0.1% per year for documentary credit in amounts below about 1.2 million Euros;
● Confirmation fees: This amount varies with the degree of risk, generally around 0.2% per quarter;
● Document collection fees: 0.15%;
● Payment, acceptance and negotiation fees: about 0.15%. There are also fees charged for documentary credit management (Telex, modifications, etc.).
Note that: Fees are not necessarily borne by the exporter. In fact, the parties may decide beforehand whether the buyer or the seller will pay the costs of the transaction. It is customary for the buyer to pay the fees of the issuing bank in its country. The seller bears the fees of the second bank (notifying or confirming).
Documentary credit negotiation generally takes place during the business negotiations. This discussion, which is crucial to ensure compliance with the procedure, aims to define the principle and terms and conditions of the documentary credit as the means of payment (at sight, differed or negotiated). In all cases, the defined due date must be mentioned in a document. The negotiation serves to define the details of:
● The type of credit (revocable, notified or confirmed);
● The list of required documents;
● The incoterm used;
● Whether the seller or the buyer will pay the fees.
Note that: Documentary credit is independent of the contract of sale and the shipping contract.
Although advantageous in many ways, documentary credit still has a few drawbacks, starting with the tedious procedure. In order to comply with the clauses and meet the deadlines, it requires a thorough approach. The formalism should not be underrated in everyday business. Another point to which attention should be paid: the average cost is higher than other payment and collection methods. The cost is proportional to the risk and varies between 1% and 3%. It is usually less expensive to use credit insurance. Finally, always pay attention to the documents received. It is not uncommon to find differences between the information entered on the documents and the goods actually delivered (mistakes in the description of products, in the reading of documents or even fraud on the goods shipped).
As you can see, documentary credit can be a great help when it comes to securing international transactions.
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