Documentary Credits

A documentary credit is an irrevocable undertaking by a bank to make payment to an exporter upon presentation of documents that comply with the terms and conditions specified in the credit. This moves the credit risk from the buyer to the bank. Documentary credits are independent of the underlying commercial contract – the bank’s obligation is tied solely to whether the documents presented comply with the terms of the credit. As long as an exporter can makes a complying presentation (e.g., a bill of lading, commercial invoice, insurance certificate, etc. as stipulated in the credit), they are entitled to payment under the credit regardless of the financial status of the buyer, their willingness to pay, or any disputes regarding the underlying goods.

The parties involved

A typical documentary credit transaction involves a handful of key parties:

• •       The applicant (i.e., the importer): The applicant (i.e., the importer): The party that requests the LC.
  •       The beneficiary (i.e., the exporter): The party who receives payment, upon making a presentation complying with the terms of the credit.
  •       The issuing bank: The importer’s bank – they undertake to pay on a complying presentation.
  •       The advising bank: Typically, a bank in the exporter’s country – receives the LC from the issuing bank and notifies the credit to the beneficiary.
  •       The confirming bank: An optional party – adds its own payment undertaking to the credit at the request or authorisation of the issuing bank.
    

The documentary credit process

Broadly speaking, the applicant/importer makes a request for the documentary credit to be issued by the bank, offering the irrevocable undertaking of paying the exporter/beneficiary based on a complying presentation of documents.
More specifically, the documentary credit process generally follows a predictable sequence that ensures both parties are suitably protected:

1. The importer and exporter sign a sales contract specifying the use of a documentary credit as the payment method.
2. The importer applies to their bank (i.e., the issuing bank) to open a credit in favour of the exporter.
3. The issuing bank sends the documentary credit to the exporter’s bank (i.e., the advising bank) in the exporter’s country.
4. The exporter’s bank satisfies itself to the apparent authenticity of the credit and informs the exporter of the credit’s terms and conditions.
5. Upon verifying the terms are acceptable to it, the exporter agrees to perform under the credit.
6. The exporter compiles the required documents and presents them to a nominated bank (or directly to the issuing bank).
7. The nominated bank examines the documents to determine if they comply with the credit terms; the nominated bank may pay the beneficiary early if the presentation is complying, and foreards the documents to the issuing bank for reimbursement.
8. The issuing bank examines the documents and if complying, reimburses the nominated bank when due.
9. The applicant collects the documents from the issuing bank, and may require the documents to take delivery of the goods.

Types of documentary credits

Documentary credits are fairly flexible and can be adapted to meet the nuanced needs of specific transactions:

Irrevocable vs revocable documentary credit

Most modern credits are irrevocable – i.e., they cannot be cancelled or modified without all parties consenting. Revocable credits that can be altered or cancelled by just the issuing bank alone are therefore rare, as they offer little security. In fact, they fail the definition of credit in UCP 600, as all credits under UCP 600 are irrevocable.

Confirmed vs unconfirmed documentary credit

In a confirmed credit, a second bank (generally the exporter’s bank) adds its undertaking to pay, offering greater security. This is commonly done to mitigate political or financial risks. Non-confirmed credits, conversely, rely solely on the issuing bank.

Transferrable documentary credit

Transferrable credits allow the beneficiary to transfer all or part of the credit to a third party. These credits are typically used by traders or other intermediaries involved in a transaction between the buyer and the exporter.

Revolving credit

This describes a single credit that covers multiple shipments over a given period of time. The credit amount ‘revolves’ or automatically renews after each shipment is settled, which is highly efficient in recurring trade relationships.

Sight Payment vs Usance

A sight payment LC is honoured by payment at sight upon determination that a presentation complies. A usance LC may be available by deferred payment, acceptance or negotiation, and the due date for a complying presentation is at the end of the tenor specified in the credit, e.g. 45 days after shipment or some other reference date.

Strategic benefits of documentary credits

For the exporter in an international trade transaction, the primary benefit of documentary credits is fairly obvious – security. The risk of non-payment is moved from the importer to the bank, which has an obligation to pay when presented with complying documentation, regardless of the situation of the importer. On top of this, a documentary credit can also often be used as a basis for exporters to secure pre-shipment financing.
For importers, the benefit really lies in the ‘documentary’ nature of the instrument. They have the assurance that payment will only be released once the exporter provides documents according to the agreed terms timely, ensuring they aren’t parting with funds before the exporter has met their documentary obligations.

Risks of documentary credits

The benefits of documentary credits, though, come with considerations of their own. For one, there’ a degree of complexity to the agreement. The documentary credit process is governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), which requires precise adherence to instructions. Discrepancies in paperwork can lead to the refusal of payment to exporters if the issuing bank and/or the applicant declines to provide a waiver for the discrepancies.
Documentary credits also incur costs. Banks charge fees for the issuance, advising, confirmation, and amendment of credits. There are also operating burdens to consider – ensuring the security of payment for an exporter involves correctly preparing the required documentation, which can be time-consuming and require significant administrative oversight.