A direct pay letter of credit is a special form of standby letter of credit. With a direct payment letter of credit, the issuing bank directly pays to the beneficiary. It does not include any clause of performance or non-performance from the seller. Like a standby, it can provide financial security to the seller by the presentation of the payment draft.
A direct pay letter of credit differs from standby in the sense that it acts as a primary source of payment to the seller. Whereas, a standby LC is used to make payments in case of default of the buyer. In both forms, the issuing bank bears the responsibility of non-payment by the applicant.
What is a Direct Pay Letter of Credit?
In a direct pay letter of credit or simply direct pay LC, the advisory bank makes a direct payment to the beneficiary. The issuing bank clears the payment upon payment draft presentation by the beneficiary. Unlike a standby, the beneficiary does not need to present the documents on default of the buyer only.
The direct pay LC works independently from the trade agreement. Hence, it offers discrete financial security to both parties in the trade agreement. On the other hand, it also possesses similar risks to the applicant and the issuing bank. It offers a higher degree of risk as compared to a normal standby, such that it does not come with a covenant for the undertaking of a certain event happening. Although it does not happen often, the sellers can claim the payment without proceeding with the shipment of goods to the buyer.
How Does Direct Pay Letter of Credit Work?
A standby letter of credit is used to protect the buyer from the non-performance of the seller. The buyer provides a standby LC to mitigate the risk of non-payment, which helps both parties to boost the trust. A direct payment LC eliminates the condition of performance and clears the payment upon demand draft presentation by the beneficiary.
The process of a direct payment LC starts with the applicant approaching a bank. The bank appraises the applicant’s creditworthiness and approves the credit facility. Once the buyer secures a documentary credit, it can proceed with the trade deals. The buyer then issues a direct pay LC to the beneficiary.
A direct payment letter of credit is an independent contract from the trade deal. It means the buyer can seek the security of performance by the seller with a trade contract only. Once the seller approaches the bank with necessary documentation such as a payment draft, the issuing bank will release the payment.
A direct pay LCis a quick and simpler payment method in international trades. Hence, sellers usually prefer it over the complex commercial letters of credit. It works similarly as a bank guarantee that offers fewer complications and clears the payments quickly. Contrarily, it possesses a higher degree of risks too for the buyer, as the bank does not control the title of goods or the bill of lading documents.
Important Points to Note with Direct Pay Letter of Credit
A Direct payment letter of credit is a special form of standby letter of credit. Its working mechanism closely resembles that of a standby documentary credit. The primary purpose of a direct payment LC is to secure the buyer from non-performance risk. However, the direct payment LC excludes the condition of presenting the proof of performance or a specific event.
Some key points to note with a direct payment letter of credit include:
- Unlike a common standby, a direct payment LC works as a primary source of payment.
- The beneficiary is entitled to the payment upon presenting the payment draft to the issuing bank.
- The beneficiary does not need to contact the buyer or present complex documents as proof of a certain event to the bank to claim the payment.
- The issuing bank does not need to make the payment on the buyer’s default only.
- The issuing bank does not bear the risk of non-performance from the seller.
The standby documentary credit is issued to protect the seller from the default of the buyer. The buyer is also protected with a cover of standby payment for the performance clause. However, the issuing bank makes direct payments to the beneficiary with a direct payment documentary credit and cannot control the performance clauses.
Example
Suppose a buyer company Green Star in the US approaches a seller Blue Tech in the UK. Both parties agree on a trade deal with a direct pay LC as the mode of payment.
Green Star approaches the bank ABC for a documentary credit of $100,000. The advisory bank of Blue Tech will inform of the availability of the credit. Once Blue tech fulfills the trade contract terms, and ships the goods, it can approach the bank for the payment.
Unlike a standby LC, Blue tech will directly approach the bank and present the payment draft. The bank will verify the signatures and issue the payment directly to the seller without any verification from the buyer’s side. Green Star (the buyer) can independently verify the trade terms and performance clauses though.
Advantages of Direct Pay LC
A direct pay LC is a special form of standby letter of credit that offers certain advantages to both parties in the trade deal:
- It requires simple documentation and easier to process than common commercial documentary credit letters.
- It is preferred by the sellers as it makes the payment faster.
- The buyer may be in a position to negotiate trade prices.
- It used a primary source of payment, unlike a standby that is used as a secondary mode of payment as a cover only.
- It works independently from the trade contract terms, hence simplifies the payment mechanism in large trade deals.
Disadvantages of Direct Pay LC
Apart from the simplicity, a direct payment letter of credit also comes with certain disadvantages as compared to other documentary credits.
- The issuing bank may not issue a direct payment letter of credit easily.
- The issuing bank bears the risk of default from the buyer.
- It is an unsecured payment method, as it does not fully mitigate the risk of default and non-performance from both parties in the trade deal.
- If the local bank does not approve a direct payment LC, the buyer may not find a suitable option to obtain the facility.
- The beneficiary may withdraw the payments without contacting the buyer in the first place.
Conclusion
A direct payment letter of credit comes with a direct payment feature to the beneficiary. It requires less documentation and is a simpler payment method. The direct pay LC is used as a primary mode of payment, unlike a standby LC that is used as a cover for the buyer’s default. It is a riskier payment option for all parties in the trade deal, including the issuing bank.