Documentary Credits

The parties involved

A typical documentary credit transaction involves a handful of key parties:

• •       The applicant (i.e., the importer): The buyer who initiates the request and provides the funds/credit line.
  •       The beneficiary (i.e., the exporter): The seller who receives payment, upon meeting the terms of the credit.
  •       The issuing bank: The importer’s bank – they assume the primary obligation to pay.
  •       The advising bank: Typically, the exporter’s bank – handles the notification of the credit and ensures its authenticity.
  •       The confirming bank: An optional party – adds its own payment guarantee to the credit, offering the exporter an added layer of security if they’re concerned about, say, the creditworthiness of the issuing bank or political risk in the importer’s country.
    

The documentary credit process

Broadly speaking, the applicant/importer makes a request for the documentary credit to be issued by the bank, offering the irrevocable undertaking of paying the exporter/beneficiary.

More specifically, the documentary credit process generally follows a predictable sequence that ensures both parties are suitably protected:

1.     The importer and exporter sign a sales contract specifying the use of a documentary credit as the payment method.
2.     The importer applies to their bank  (i.e., the issuing bank) to open a credit in favour of the exporter.
3.     The issuing bank sends the documentary credit to the exporter’s bank (i.e., the advising bank) in the exporter’s country.
4.     The exporter’s bank verifies the authenticity of the credit and informs the exporter of the credit’s terms.
5.     Upon verifying the terms, the exporter then ships the goods.
6.     The exporter collects the required shipping documents and presents them to their bank (or directly to the issuing bank).
7.     The bank(s) reviews the documents for strict compliance against the credit terms; if they comply, payment is processed and the documents are forwarded to the issuing bank, allowing the importer to claim the goods.

Types of documentary credits

Documentary credits are fairly flexible and can be adapted to meet the nuanced needs of specific transactions:

Irrevocable vs revocable documentary credit

Most modern credits are irrevocable – i.e., they cannot be cancelled or modified without all parties consenting. Revocable credits that can be altered or cancelled by just the buyer alone are therefore rare, as they offer little security. In fact, modern standards have effectively rendered them obsolete as all credits are assumed to be irrevocable.

Confirmed vs unconfirmed documentary credit

In a confirmed credit, a second bank (generally the exporter’s bank) adds its guarantee to pay, offering greater security. This is common in high-risk markets to mitigate political or financial risks. Unconfirmed credits, conversely, rely solely on the issuing bank.

Transferrable documentary credit

Transferrable credits allow the beneficiary to transfer all or part of the credit to a third party. These credits are typically used by traders or other intermediaries involved in a transaction between the buyer and the exporter.

Revolving credit

This describes a single credit that covers multiple shipments over a given period of time. The credit amount ‘revolves’ or automatically renews after each shipment is settled, which is highly efficient in recurring trade relationships.

Strategic benefits of documentary credits

For the exporter in an international trade transaction, the primary benefit of documentary credits is fairly obvious – security. The risk of non-payment is moved from the importer to the bank, which has an obligation to pay when presented with the relevant documentation, regardless of the situation of the importer. On top of this, a documentary credit can also often be used as collateral for exporters to secure pre-shipment financing.

For importers, the benefit really lies in the ‘documentary’ nature of the instrument. They have the assurance that payment will only be released once the exporter provides verified, compliant documentation proving that the goods have indeed been shipped according to the agreed terms, ensuring they aren’t parting with funds before the exporter has met their obligations.

Risks of documentary credits

The benefits of documentary credits, though, come with considerations of their own. For one, there’ a degree of complexity to the agreement. The documentary credit process is governed by the Uniform Customs and Practice for Documentary Credits (UCP 600), which requires precise adherence to instructions. Even minor discrepancies in paperwork can lead to the refusal of payment to exporters or costly delays while the exporter seeks a waiver or amendment.

Documentary credits also incur their own costs. Banks charge fees for the opening, advising, confirmation, and amendment of credits. There are also operating burdens to consider – ensuring the security of payment for an exporter involves correctly preparing the required documentation to confirm shipping, which can be time-consuming and require significant administrative oversight.