Documentary Credit – An introduction | Trade Samaritan

Documentary Credit – An introduction

A letter of credit is a document issued by a financial institution, or a similar party, assuring payment to a seller of goods and/or services provided certain documents have been presented to the bank.

The past 20 years have seen a dramatic fall in trade barriers, the globalization and consolidation of markets, and a huge growth in international trade. Companies, banks and financial institutions of all sizes are seeking to take advantage of the opportunities in this new world economy. International transactions, however, add an additional layer of risks for buyers and sellers familiar only with doing business in their domestic markets. Currency regulations, foreign exchange risk, political, economic, or social upheaval in the buyer’s or seller’s country, questions of payment, and different business customs may all contribute to uncertainty. Ultimately, sellers want to get paid and buyers want to get what they pay for. Choosing the right payment method can be the key to a transaction’s feasibility and profitability.

Since cash in advance happens to be the most secured payment for the exporter and least secured to the importer, and vice a versa for open account, Documentary credit (DC) stands out to be one of the most secured and apt forms of payment for all parties for cross border trade transactions.

As per ICC – International Chamber of Commerce 2012 Global Survey Results and Findings, Letters of credit were the major product handled on both the import and export side, at 44% of the volume of transactions received (up from 42% in 2011 survey).

Definition of Letter of Credit (LC):

Credit means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation.” (Uniform Customs and Practices for Documentary Credits UCPDC 600, article 2).

OR

An irrevocable Credit constitutes a definite undertaking of the Issuing Bank provided that the stipulated documents are presented to the Nominated Bank or to the Issuing Bank and that the terms and conditions of the Credit are complied with.

LC transactions and LC Documents are governed by UCPDC 600 (Uniform Customs and Practices for Documentary Credits) framed by ICC-International Chamber of Commerce.

The average Letter of credit will require atleast following documents:

Letter of credit documents

  • Drafts – Drafts are drawn on the issuing bank or the confirming bank. Drawee on such bills will be a bank rather than the buyer. The bills will reflect whether the letter of credit is payable at sight or contains a credit term. In both the cases the bill will contain a clause referring to the relevant letter of credit.
  • Export invoice – Export invoices will be required in a prescribed format and in sufficient numbers.
  • Insurance policy or certificate – This will be required for terms CIF (Cost Insurance and freight) and CIP (Carriage and Insurance paid)
  • Transport document – Transport document could be bills of lading, air way bill, road or rail consignment note or a freight forwarder’s receipt.

When compared with a bank guarantee or a standby letter of credit, the underlying documentary nature makes a letter of credit more complicated but a fool proof and an elaborated mechanism of payment both domestic as well as cross border. A letter of credit ensures that all the documents like invoice, transport document, bill of exchange, certificate, packing list, attestations, stamps, signatures and specifications are up to date and fully compliant.

The ICC survey 2012 was conducted across top 229 banks (including the World bank) located in 110 countries which indicated a rise in the following areas:

  • confirmation requests
  • discrepancy rate
  • refusals
  • fraud allegations
  • number of claims in Standby Letter of Credits and Guarantees

Any valid discrepancy minor or major holds the power of making the letter of credit and its inherent security totally invalid hence drafting and negotiating the final terms between the exporter (beneficiary), importer (applicant) and the issuing bank is of utmost importance. The above stated adverse trend has made  the knowledge of documentary credit, underlying documents and the universal as well as the local rules imperative in today’s world.

References

International Chamber of Commerce

 

 

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