Documentary credits are a bank document that guarantees payment. There are several types of documentary credits, and they can provide security when buying and selling products or services.
Seller Protection:
If the buyer fails to pay the seller, the bank that issued the documentary credit must pay the seller as long as the seller meets all the requirements stipulated in the credit. This provides security when the buyer and seller are in different countries.
Buyer Protection:
Documentary credits can also protect buyers. If you paid someone to deliver a product or service and they fail to deliver, you may be able to get repayment using a documentary credit. This payment can serve as a penalty to the company that failed to perform, somewhat similar to a refund. With the money you receive, you can pay someone else to provide the required product or service.
If you are familiar with surety services, the concept is similar: banks act as “impartial” third parties. The bank does not side with anyone and only releases the funds after specific conditions have been met. Documentary credits are common in international trade but are also useful for local transactions such as construction projects.
The Money Behind Documentary Credits
The bank promises to pay on behalf of the client, but where does the money come from? The bank issues the documentary credit only if it is confident in the buyer’s ability to pay. Some buyers might need to pay the bank in advance or allow the bank to freeze the funds held in the bank. Others may use a line of credit with the bank, which means obtaining a loan from the bank.
Sellers must trust that the bank issuing the documentary credit is legitimate and that the bank will pay as agreed. If sellers have any doubts, they can use a “confirmed” documentary credit, meaning that another bank (likely more credible) will guarantee the payment.
When is Payment Made?
The beneficiary is paid only after specific procedures are performed and the requirements stated in the documentary credit are met. In international trade, the seller may need to deliver the goods to the shipping dock to satisfy the documentary credit requirements. Once the goods are delivered, the seller receives documents proving the delivery, and these documents are sent to the bank. In some cases, simply shipping the goods will trigger the payment, and the bank must pay even if something happens to the shipment. If a crane falls on the goods or the ship sinks, this is not necessarily the seller’s problem.
Document concerns: To approve payment under the documentary credit, banks review the documents proving that the seller has carried out any required actions.
The bank does not care about the quality of the goods or any other elements that may be important to the buyer and seller. This does not necessarily mean that sellers can send a shipment of inferior goods. Buyers can insist on an inspection certificate as part of the deal, which allows someone to review the shipment and ensure that everything is acceptable.
For the “performance” transaction, the beneficiary (the buyer or anyone receiving the payment) may need to prove that someone failed to do something. For example, a city may hire a contractor to complete a construction project. If the project is not completed on time (and a documentary credit was used), the city can show the bank that the contractor did not meet their obligations. As a result, the bank must pay the city. This payment compensates the city and makes it easier to hire an alternative contractor to finish the work.
What Can Go Wrong?
Documentary credits make it possible to reduce risks while continuing to do business. They are important and useful tools, but they only work when you get all the details right. A minor mistake or delay can wipe out all the benefits of a documentary credit.
If
If you are relying on letters of credit to receive payment, make sure to:
- Review all documentary credit requirements carefully before approving any transaction.
- Understand all the required documents. If you are unsure about something, ask your bank.
- Be able to obtain all necessary documents for the letters of credit.
- Understand the time limits associated with the letters of credit, and whether they are reasonable or not.
- Know how quickly your service providers (shipping companies, etc.) can produce the documents for you.
- Be able to get the documents to the bank on time.
- Check all documents required by the letters of credit and ensure they match the letter of credit request exactly. Even typographical errors or common substitutions can cause problems.
International Trade
Importers and exporters regularly use letters of credit to protect themselves. Working with a foreign buyer can be risky because you don’t really know who you are dealing with.
The buyer may be honest and have good intentions, but business problems or political unrest can delay payment or cause the buyer to go bankrupt.
Moreover, communication can be challenging across thousands of miles, different time zones, and different languages. Letters of credit specify the details so that everyone is on the same page. Instead of assuming things will work out a certain way, everyone agrees on the process up front.
Terms of Letters of Credit
To better understand letters of credit, it is useful to know the terminology.
- Applicant: The party requesting the letter of credit. This is the person or organization that will pay the beneficiary. The applicant is often an importer or buyer using the letter of credit to make a purchase.
- Beneficiary: The party receiving the payment. This is usually a seller or exporter who asked the applicant to use the letter of credit (as the beneficiary wants more security).
- Issuing Bank: The bank that creates or issues the letter of credit at the applicant’s request. This is typically the bank that the applicant is already doing business with (in the applicant’s country, where the applicant has an account or line of credit).
- Advising Bank: The bank working with the beneficiary. This bank is often located in the beneficiary’s country and may be the bank that the beneficiary is already working with. The beneficiary presents documents to the advising bank, and the advising bank acts as an intermediary between the beneficiary and the other banks involved.
Source: https://www.thebalancemoney.com/how-letters-of-credit-work-315201
Leave a Reply