Documentary Credit, step by step

The documentary credit is one of the most widely used payment instruments in international trade, since it manages to reconcile the commercial interests of the buying and selling companies with the security and guarantee offered by banking entities that act as issuers and intermediaries in the operation.

What do we understand by documentary credit or letter of credit in international trade?

The documentary credit or letter of credit is the means of payment that offers the highest level of security in international trade operations. It acts as a financing and guarantee mechanism for the parties that enter into a contract for the international sale and purchase of goods. The bank issuing the credit guarantees the operation, so that the selling party has the guarantee of collection, while the buying party has the guarantee that it will only pay when the conditions for delivery of the goods have been fulfilled. That is to say, provided that one party and the other comply with the conditions indicated in the instructions of the purchase and sale transaction.

This means of payment, also known as letter of credit (L/C), is activated when the buyer (importing company) gives its bank (issuing bank) an order to proceed with the payment of the value of an international purchase and sale transaction, at the moment that the bank (confirming bank) of the seller (exporting company) presents the documentation that proves the delivery or shipment of the purchased merchandise, according to the agreed conditions.

Characteristics of the documentary credit or letter of credit

The documentary credit is particularly suitable for international sales and purchases because it has these characteristics:

• It is irrevocable, if the agreed conditions are met, and can only be cancelled or modified by mutual agreement of all parties involved.
  Independence of the parties with respect to the issuing and confirming banks.
• It has a documentary nature, i.e., the movement of funds is carried out through the exchange of commercial or financial documents, which confer possession of the goods.
• It is regulated by the rules of the International Chamber of Commerce (ICC) through the Uniform Customs and Practice for Documentary Credits, known as UCP 600 rules.

The five steps in managing a letter of credit

The process followed by a documentary credit can be summarized in these five steps:

1. Opening of the credit: the importing company instructs its bank (issuing bank) to open a documentary credit on the basis of an offer formalized in a pro forma invoice issued by the exporting company. The buyer indicates to the seller the documentation to be sent to the bank. The issuing bank arranges with the bank of the supplier company (confirming bank) to notify the latter of the opening of the credit and sends it a draft with its clauses so that it can verify it and express any possible disagreement that could lead to a future incident.
2. Documentary management: the credit clauses detail the documents that the exporting company must make available to the importer through the confirming bank and which accompany the operation. Among these, the most common are: commercial invoice, shipping list, contracts relating to the operation and product catalogs, certificates (health, origin, etc.), insurance policy and transport document, among others. The preparation and presentation of the documentation must be extremely meticulous for each of the documents that have been requested. Any error or inaccuracy may cause a discrepancy and the issuing bank may not proceed with the payment, while waiting for it to be corrected.
3. Shipment of the goods: the exporting company proceeds to ship the goods to the destination or the agreed place under the delivery conditions agreed with the importer.
4. Sending the documentation through the bank: the exporting company, through its bank (confirming bank), sends the documentation proving the shipment or delivery of the goods to the importer’s bank. The issuing bank receives the documentation sent by the exporter and checks that everything is in order.
5. Payment: if the documentation received is in order, the bank of the importing company irrevocably pays the value agreed in the sales contract, while the importing company presents the documents at the agreed place and proceeds to pick up the goods.

Document management agents

The documentary management of a documentary credit is mainly formalized through these agents:

• The forwarding company, in addition to projecting and directing all the operations necessary for the international transport of goods under a single contract with the loading company or client, offers essential services, such as customs management, and supplies all the documentation related to these operations.
• The insurance company, which together with the policy contracted can issue the corresponding insurance certificate.
• The chamber of commerce, which can perform legalizations and issue certificates of origin, temporary admission of goods (ATA) carnets, among others.
• Third party agencies, such as embassies, to carry out legalizations of documents, or international certifying entities, for certain certifications on the products being exported.
• Banks, which can provide bills of exchange related to documentary credit or currency exchange insurance, for example, among other documents related to the form of payment.

Although the documentary credit is one of the most used payment instruments in international trade, its management requires previous knowledge, high rigor and impeccable organization, for which it is sometimes essential to have the support of professionals with proven experience in international trade.

Cargo Flores provides comprehensive and multidisciplinary solutions in foreign trade, especially focused on SMEs that must operate with third countries. Our capacity as an international logistics operator contributes to streamline all the necessary documentary procedures for the management of documentary credits and avoid possible incidents.

 

Information & Resources
International Chamber of Commerce

LinkedIn groups as a consultation tool:
«International Payment Methods» Group
«CDCS – Letter of Credit» Group