How Letters of Credit (Documentary Credits) work

 

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Letters of Credit, also known as Commercial and Documentary Credits, are used to guarantee payment to the seller and delivery of goods to the buyer.  Payment is exchanged for documents in the Letter of Credit cycle provided that the stipulated documents are presented correctly and the terms and conditions of the Letter of Credit are complied with.

The basic Letter of Credit operation is as follows.  Please note that variations of this procedure can occur.  This basic procedure covers the movement of goods and services.

•  The Buyer (as Applicant) completes a bank application form requesting that their bank (as Issuing Bank) issues a Letter of Credit in favour of the Seller (the Beneficiary).

This form should include details such as the documents to be presented, the terms and conditions to be complied with and the payment period agreed.

•  The Issuing Bank issues a Credit in favour of the Beneficiary stating its irrevocable undertaking to pay the Beneficiary on condition that all documents requested have been presented and all terms and conditions are complied with.

Please note that this undertaking is enforceable against the Issuing Bank even if the Buyer is unwilling or unable to pay.  Consequently, once a Letter of Credit is issued it cannot be cancelled by the Buyer without agreement from all parties, or until it expires.

•  The Issuing Bank will ask a bank in the Seller’s country with which it has a correspondent banking relationship (the Advising Bank) to notify/advise the credit to the Beneficiary.

•  Once advised the Credit may be payable at the counters of the Issuing Bank; the counters of a specific nominated bank in the Beneficiary’s country or at the counters of any bank in the case of a freely negotiated Credit.  The Nominated bank is usually the Advising Bank.

•  A Letter of Credit can be confirmed by a bank (the Confirming Bank) in the Beneficiary’s country.  When a Letter of Credit is confirmed, it is payable at the counters of the Confirming Bank.

A confirmation of a Letter of Credit is a separate undertaking from that of the Issuing Bank.  Confirmations are chargeable and can be costly.  It is not absolutely necessary to have a Confirmed Letter of Credit, but in some circumstances it is strongly advised to do so.

•  When the Credit is advised to the Beneficiary two documents are issued.  The Letter of Credit itself and an additional letter from the Advising Bank detailing out who the documents should be presented to and the bank address the documents must be sent to.  This could be the Advising Bank, a specific Nominated Bank or any bank if the Credit is freely negotiable.  If the Letter of Credit is Confirmed, the presentation of documents is always to the Confirming Bank.

Sometimes this address is different from the branch issuing the letter.  Always check to ensure that the instructions on presentation of documents is clear and unambiguous.  If not, contact the Advising bank and obtain clear instructions.

•  The Beneficiary despatches the goods and presents the stipulated documents to the bank.  The documents must be compliant with the Letter of Credit terms and conditions and in accordance with UCP (Uniform Customs and Practices) 600.

UCP 600 is the current set of rules issued by the ICC (International Chamber of Commerce), which apply to the Credit when the text of the Credit expressly indicates that it is subject to these rules.

•  The Nominated/Confirming Bank may pay the Beneficiary provided the stipulated documents have been presented and the terms and conditions of the Credit have been complied with.  The Nominated Bank then sends the documents to the Issuing Bank.

•  The Buyer (Applicant) obtains the documents upon payment to the Issuing Bank and uses these documents to effect delivery of the goods.

This is the second article in the series on Getting paid with Letters of Credit.  Please do check out the other articles in this series.

Maria Narancic from Point to Point Export Services is an independent international trade adviser who assists organisations world wide with their international trade projects, documentation, Documentary Credits and import/export training. She is based in the United Kingdom. If you require any further assistance with the matters mentioned above, please do contact us by e-mail on info@point-point.com or to access other articles on International Trade matters please do check out our website at www.point-point.com

 

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