Documentary Credit

Documentary credit, commonly known as a letter of credit (LC), is a financial instrument widely used in international trade transactions to mitigate the risks associated with buying and selling goods across borders.

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It is essentially a written commitment by a bank (the issuing bank) on behalf of the buyer (the applicant) to pay the seller (the beneficiary) a specified amount of money, provided that the seller meets certain conditions outlined in the letter of credit.

Here’s how documentary credit works and its key components:

1. Initiation: The buyer (importer) and seller (exporter) agree to use a letter of credit as the method of payment in their transaction. The buyer applies for the letter of credit from their bank (the issuing bank), specifying the terms and conditions of the credit, including the amount, expiry date, documents required, and shipping terms.
2. Issuance: Upon receiving the buyer’s request, the issuing bank evaluates the buyer’s creditworthiness and decides whether to issue the letter of credit. Once approved, the issuing bank issues the letter of credit to the seller or their bank (the advising bank), conveying the bank’s commitment to honor the payment obligations outlined in the credit.
3. Terms and Conditions: The letter of credit contains detailed terms and conditions that the seller must fulfill to receive payment. These typically include specifications regarding the documents required (e.g., commercial invoice, bill of lading, packing list), the quality and quantity of goods to be shipped, the shipping method, and any other requirements agreed upon by the buyer and seller.
4. Shipment and Presentation of Documents: The seller ships the goods to the buyer and prepares the required documents as per the terms of the letter of credit. These documents are presented to the advising bank or the issuing bank, along with a written request for payment. The documents serve as proof that the seller has fulfilled their contractual obligations.
5. Examination and Payment: The advising bank or the issuing bank examines the documents to ensure they comply with the terms and conditions of the letter of credit. If the documents are found to be in order, the bank honors the payment obligation and disburses the agreed-upon amount to the seller or their bank. If discrepancies are found, the bank may seek clarification from the buyer or request amendments to the documents.
6. Settlement: Once payment is made to the seller, the buyer receives the documents necessary to take possession of the goods from the carrier or customs authorities. The buyer assumes responsibility for the goods and any further costs associated with transportation, customs clearance, and delivery to the final destination.
7. Dispute Resolution: In case of disputes or discrepancies regarding the documents or the shipment, the buyer and seller may resolve the issue through negotiation, arbitration, or legal proceedings, depending on the terms of the letter of credit and applicable laws.

Overall, documentary credit provides a secure and reliable method of payment for international trade transactions, giving assurance to both buyers and sellers that payment will be made upon the fulfillment of specified conditions. It helps mitigate risks associated with non-payment, delivery of substandard goods, or disputes over contractual obligations, thereby facilitating smoother and more secure international trade.