A documentary letter of credit, documentary credit, or a letter of credit is a promise to pay the beneficiary by a financial institution. It serves as a financial guarantee to the beneficiary for the payment if somehow the applicant cannot make the payment on time. It comes with several features and types that help both parties in international trade to smoothen the trade process. The banks play an important role in facilitating the movement of documents and money, with verification and financial security services.
What is a Documentary Letter of Credit?
A documentary letter of credit (DLC) is a promise by the bank that the beneficiary will receive the payment with the correct amount and on-time. Depending on the type, the bank may offer the facility to the applicant as confirmed, fully funded, or as a standby promise of payment.
Usually, a documentary letter of credit is irrevocable, non-transferable, and confirmed promise made by the bank. The bank requires collateral against issuing the facility and charges a fixed percentage of the DLC value as commission.
How Does Documentary Letter of Credit Work?
International trade involves complex documentation and payment procedure due to different regulatory and law requirements. An importer can contact a potential seller in a different continent, the shipment of goods may go through several jurisdictions before it reaches the final destination. A documentary letter of credit plays a crucial role in developing the trust and facilitating the payment process to both parties in the trade.
Parties involved in a documentary letter of credit:
- The buyer – Applicant of the DLC.
- The seller – Beneficiary of the DLC, or first beneficiary.
- The Issuing bank – from the applicant side.
- The confirming bank and nominated bank – from seller side and sometimes common facilitators.
A documentary letter of credit is a negotiable instrument, meaning the issuing bank will pay the nominated bank of the beneficiary. If the DLC specifically states, the issuing bank can transfer the funds to the nominated secondary beneficiary as well.
Process of Documentary Letter of Credit
Let us go through the working process of the documentary letter of credit.
1. The buyer approaches a seller to buy goods. Both parties decide on the price, quantity, shipment method, and mode of payment. The seller would want to receive the payment with a documentary letter of credit as it offers financial security.
Important: The trade agreement between both parties remains a separate legal document. A documentary letter of credit is issued by a bank and regulated separately.
2. The buyer approaches a local bank to issue a documentary letter of credit. The DLC must include the terms and conditions of the document collection, due amount, shipment details, beneficiary, the type of LC, and the due date of payment.
3. The bank appraises the creditworthiness of the applicant. The bank will issue the DLC upon receiving collateral from the applicant. The DLC type will depend on the applicant’s requirements such as the irrevocability, transferability, and confirmation clause.
Important: The bank becomes a guarantor for the payment, hence would need the funding upfront or collateral. The bank may offer the DLC as a financing facility as well.
4. The bank issues a documentary letter of credit and sends it to the advisory bank of the beneficiary (Seller). If there is a confirming bank, the advisory bank will approach it for the confirmation process as well.
5. Once the seller receives a confirmation of the DLC from the bank, it can arrange for the shipment of goods as specified. The seller will send the necessary shipping documents to the advising bank including bill of lading, insurance policy, invoices, and freight bill.
6. The advising bank will proceed with the documents to the issuing bank. The issuing bank will verify the documents and release the funds to the advising bank. The buyer will receive the shipping documents to receive the goods at the specified port.
7. The seller will receive the payment, once the issuing bank of DLC releases the funds to the advising bank.
Types of Documentary Letter of Credit
Although a documentary letter of credit offers significant financial security, both parties may need further satisfaction. One way of doing it is to choose from the several types of documentary letters of credit available.
Commercial Letter of Credit
A standard form of documentary credit in which the bank acts as a neutral facilitator to proceed with the payment if all conditions are fulfilled.
Fully Funded Documentary Letter of Credit
It is a form of a standard letter of credit where the bank holds the applicant’s funds separately before issuing the DLC. The applicant provides the funds upfront, hence it is called a fully funded DLC.
Standby Letter of Credit
A standby letter of credit works as a backup plan for the seller if the buyer fails to make the payment on time with the first letter of credit. It is issued separately from the standard commercial DLC and provides additional security to the beneficiary.
Confirmed and Non-Confirmed Letter of Credit
In this form of a documentary letter of credit, a second bank acts as the confirming bank for the payment. The confirming bank is nominated by the seller. If the buyer and the issuing bank fail to make the payment, the confirming bank takes the responsibility.
Transferable and non-transferable Letter of Credit
By default, a letter of credit is non-transferable and only the primary beneficiary (through the advising bank) can receive the funds. However, the sellers may need to make payments to their suppliers and ask for the transferability clause. The seller can then transfer part or the full payment to another beneficiary.
Revolving Letter of Credit
The revolving letter of credit is a type of documentary letter of credit that allows the applicant to use the facility multiple times with one approval from the bank. The applicant can issue several DLCs up to the approved documentary credit limit.
Red or Green Clause Letter of Credit
- Allows the beneficiary to receive advance payment by presenting the documents such as warehouse receipts.
- A clean red clause further facilitates the seller and does not require any proof of goods.
A green Clause letter of credit also provides advance payment to the seller but requires proof of goods purchase and storage. The proof remains with the bank until the transaction completes.
Sight Letter of Credit
In the sight letter of credit arrangement, the bank must release the payment as soon as the seller presents the shipping documents. The bank can verify the document but needs to release the funds immediately.
Advantages of Documentary Letter of Credit
A documentary letter of credit is a great enabler of international trade. It serves many benefits to both parties in international trade.
Documentary letter of credit has several advantages:
- DLC helps in international business expansion.
- DLC provides financial security to both parties in international trade.
- It comes with several features and types making it a highly customizable instrument.
- It acts as facilitating instrument for payment, working capital, and financial security simultaneously.
- Both parties can secure their interests with different features.
- Enables businesses to plan better for large cash flow projects.
Disadvantages of Documentary Letter of Credit
With all its benefits and flexibility of several options, it also serves some limitations to both parties.
- The bank cannot fully ensure the payment to the beneficiary, in case there is litigation or other factors in a trade dispute.
- DLC does not remove the financial currency risk for the beneficiary.
- It is a costly and sophisticated instrument that may not be accessible for small businesses easily.
- It cannot reduce the financial risks due to political, geographical, or macroeconomic factors.
A documentary letter of credit is a means of financial guarantee and secure mode of payment in international trade. It comes with several features and is a highly customizable instrument. It comes with the backing of two banks as facilitators.