Documentary letters of credit

21 Jul Documentary letters of credit

A documentary letter of credit is an undertaking of the bank, which has opened a letter of credit on request of a buyer (applicant) to pay an amount to the seller (beneficiary) as specified in the letter of credit upon the provision of documents by the seller (beneficiary) that meet the conditions of the letter of credit and confirm the shipment of  commodities (the provision of services) within the prescribed time frame.

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If you’re familiar with escrow services, the concept is similar: Banks act as “disinterested” third parties. The bank doesn’t take anybody’s side, and banks release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also helpful for domestic transactions like construction projects.

 Example

• • A manufacturer receives an order from a new customer overseas. The manufacturer has no way of knowing if this customer can (or will) pay for the goods after producing and shipping the products.
  • To manage risk, the seller uses an agreement that requires the buyer to pay with a letter of credit as soon as shipment is made.
  • To move forward, the buyer needs to apply for a letter of credit at a bank in their home country. The buyer may need to have funds on hand at that bank or get approval for financing from the bank.

• The bank will only release funds to the seller after the seller proves that the shipment happened. To do so, the seller typically provides documents showing how goods were shipped (with details like the exact dates, destination, and contents). In some ways, the buyer also enjoys protection under a letter of credit: Buyers might prefer to pay a bank with a big legal department rather than send the money directly to an unknown seller.
• If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released.

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 Types of Letters of Credit

There can be numerous types of letters of credit. Each may or may not be funded. Some of the most common types of letters of credit include the following:

• Documentary letter of credit
• Standby letter of credit
• Secured letter of credit
• Revocable letter of credit
• Irrevocable letter of credit
• Revolving letter of credit
• Red clause letter of credit
• Green clause letter of credit

Letters of credit are used:

• if you are not certain about the solvency of your counterparty;
• if the counterparty is not certain about the proper performance of obligations by you (in terms of the quantity and quality of commodities or services);
• if you need a payment respite or trade credit;
• if you need a downpayment (advance payment) for the valuables to be supplied;
• if the counterparty insists on a settlement through letters of credit.

Advantages of  Letters of Credit For The Seller:

• elimination of the credit risk, the receipt of an undertaking from a bank (banks) to pay for commodities supplied or services provided , if the seller lacks adequate information about the financial standing of the buyer or the credit relationship;
• elimination of the risk of receipt of a counterfeit undertaking or an undertaking issued by a non-existing bank;
• elimination of the risk of non-payment / late payment / partial payment for goods supplied / services provided;
• maximum reduction in the time interval between the shipment of the commodity (the provision of services) and the receipt of proceeds;
• elimination of the risk of order abandonment (change in conditions) by the buyer without the consent (permission) of the seller;
• possibility to get short-term funding;
• possibility to increase supply volumes, to promote commodities (services) in new markets, to gain competitive advantages.

  Advantages of Letters of Credit For The Buyer:  

• a letter of credit can be opened at the buyer’s own expense or using a bank loan by pledging other collateral  to secure  performance of its obligations (a lien on assets or  a deposit, etc.);
• the buyer may withhold payment pending documentary confirmation that the goods meet the quality requirements and have been delivered in full to their specified destination  (the payment is made after the goods are have been delivered and documents provided);
• the buyer specifies a list of documents against which payment will be made;
• the buyer limits the time frames for the provision of documents and goods delivery.