Documentary credit (D/C)
- When selling your goods internationally, it is not always easy to be certain that your goods or services will be paid for, especially if you don’t know or trust the buyer of your goods very well.
- When importing goods or services from another country, you want to be confident that you will get the goods or services you have ordered and paid for at the right time.
To mitigate these risks, Luminor can help you use a documentary credit for payments, whether you are importing or exporting.
What is a documentary credit?
A documentary credit is an undertaking of the buyer’s bank to pay the seller on an agreed date, provided that the seller has submitted the documents specified in the documentary credit and which comply with all the terms and conditions of the documentary credit to the bank.
Minimize your risks
One of the main concerns for companies selling their goods internationally is that they do not always know or trust their buyers well enough and cannot therefore be sure whether the buyers are able or willing to pay for the goods or services delivered to them.
The buyers, on the other hand, want to be certain that they will actually get the goods or services they have ordered and paid for at the right time.
To mitigate these risks, Luminor offers documentary credit as a payment method.
There are two key aspects to documentary credit: the bank’s obligation to pay and the documents to be submitted.
- The buyer’s bank only has to pay against the documents listed in the documentary credit if the documents presented comply with the terms and conditions of the documentary credit and the international rules of the UCP 600.
- The Uniform Customs and Practice for Documentary Credits or the UCP 600 were issued by the International Chamber of Commerce (No. 600, 2007).
- A documentary credit is in effect a documentary payment, which means that the banks only check the documents submitted, not the shipping or the quality of the goods.
- In principle, documentary credits are independent agreements, meaning they are completely independent of any sales agreement. When handling the documentary credits, banks do not examine the sales agreement or how well the documentary credit complies with the terms and conditions of the sales agreement.
- Documentary credits are abbreviated as L/C = letter of credit and D/C = documentary credit.
A documentary credit is mostly used for larger-scale transactions, when:
- the buyer and the seller have only recently started doing business together and do not have sufficient information on each other’s business operations and solvency;
- the parties wish to reduce their risks, especially the buyer’s payment risk;
- the parties wish to acquire financing;
- one or both partners reside in regions with increased economic or political risks;
- the goods are being manufactured specially to order;
- the law or the common trading practice of the countries involved require the use of a documentary credit.
A documentary credit offers several advantages for both the buyer and the seller.
Advantages of a documentary credit for BUYERS
- A documentary credit ensures that the seller must only be paid if the seller meets all the terms and conditions of the documentary credit;
- It allows more favourable terms of payment to be negotiated, because the documentary credit issued by the buyer’s bank indicates that the buyer is a reliable and solvent business;
- The terms and conditions specified in the documentary credit, such as the price of the goods, cannot be changed unilaterally at a later stage;
- A documentary credit helps to avoid the need for making any advance payments to the seller;
- The buyer can postpone the payment, say until the funds are received from reselling the goods, while still making sure that the seller gets paid immediately after the dispatch of goods.
Advantages of documentary credit for SELLERS
- Payment is guaranteed by the issuing bank provided that the terms and conditions of the documentary credit are fulfilled, so the receipt of payment does not depend on the buyer’s solvency or willingness to pay and the payment risk from the buyer is replaced by the payment obligation of the buyer’s bank;
- The seller can also reduce any risk related to the buyer’s bank and its country of origin by applying for confirmation of the documentary credit from the seller’s own bank, the advising bank. With confirmed documentary credit, the advising bank undertakes, additionally to the issuing bank, an obligation to pay the seller for the goods, provided that the seller has submitted requested documents to the bank which comply with the terms and conditions of the documentary credit. With the confirmation of the documentary credit, the seller gets a promise from its own bank and the receipt of payment no longer depends upon the issuing bank’s decision on the compliance of sellers documents.
- Documentary credit with deferred payment can be discounted under certain conditions, meaning that the money is received as soon as the correct documents are submitted to the bank.
- Documentary credit cannot be cancelled or revoked without the consent of the beneficiary.
- If the buyer has reservations about the quality of the goods, etc., these must be settled outside the documentary credit and under the sales agreement.
Documentary credit is a documentary payment method. This means that banks examine only the presented documents and make payment in accordance with the documents. The banks are not liable for shipping or for the quality of the goods or services covered by the documents.
How does documentary credit work?
1. Before the documentary credit is issued, a sales agreement is signed between the buyer and the seller in which they agree that a documentary credit will be used as payment method.
- The buyer and the seller also have to agree on the main terms and conditions of the documentary credit and on the required documents to be presented under the documentary credit.
- They also have to negotiate who will cover the handling fees of the banks for the documentary credit.
2. The documentary credit process is initiated by the buyer (applicant of the documentary credit) who contacts their bank and applies for a documentary credit to be issued in favour of the seller in accordance with the terms and conditions and deadlines agreed in the sales agreement.
- As the documentary credit is an irrevocable payment obligation of the buyer's bank, issuance of documentary credit is dependent on credit decision.
- If favourable credit decision is granted, the buyer must then fill out an application for documentary credit at the bank. Among other things, the application needs to include the name of the beneficiary, the value and currency of the documentary credit, whether the payment term will be sight or deferred payment, a description of goods and their point of departure and shipping destination, whether or not partial shipments and transhipment are allowed, delivery term and the list of documents that the seller must submit to the bank under the documentary credit.
- In most cases, the buyer asks the seller to present such documents which the buyer needs to acquire from the seller and also which give security that the seller has fulfilled its obligations under the agreement.
3. The documentary credit is issued by the buyer’s bank (the issuing bank) in accordance with the application received from the client (the applicant) and on the condition that relevant credit decision is granted, by SWIFT message sent to the seller’s bank.
4. The seller’s bank (the advising bank) informs the seller that the documentary credit has been issued.
- The seller must first carefully read the documentary credit and examine whether it matches the terms and conditions of the sales agreement. The seller must also make sure that they are able to meet all the requirements of the documentary credit.
- If the documentary credit contains requirements that the seller is unable to meet, perhaps because the goods cannot be manufactured or dispatched by the deadline specified in the documentary credit, or some of the required documents cannot be presented, the seller must contact the buyer and request for an amendment to the documentary credit from the issuing bank.
5. The seller dispatches the goods no later than the deadline given in the documentary credit.
6.–7. Documents are issued and prepared and submitted to the bank. The seller’s bank examines whether the documents comply with the terms and conditions of the documentary credit and advises its client to make sure that all the documents meet the requirements of the documentary credit.
8. The seller’s bank sends the documents by courier to the issuing bank, where they are again examined. The issuing bank must decide within five working days whether or not the documents comply with the terms and conditions of the documentary credit.
- If the documents comply with the terms and conditions, the issuing bank must pay against the documents and does so to the seller’s bank.
- If there are conflicts or discrepancies in the documents, the issuing bank does not have to the obligation to pay and it must inform the seller’s bank of this within five working days from receipt of the documents.
9. The payment is made at sight or at deferred date according to documentary credit terms to the seller’s bank.
- With a documentary credit payable by sight, the issuing bank must pay the seller within five working days of receiving the documents listed in the documentary credit if the documents comply with the terms and conditions of the documentary credit and the UCP 600.
- If a documentary credit has deferred payment, a date is specified in the documentary credit when the buyer and the buyer’s bank must make the payment against the documents, e.g. 90 days after the goods are shipped. If there is a discrepancy in the documents, the buyer has the right to decide whether to accept the documents and payment.
10. After the documents are paid for, the issuing bank releases them to the buyer.
11. The seller’s bank transfers the money to the seller’s current account.
12. The buyer presents the documents to the carrier.
13. Once they have been cleared, the goods are handed over to the buyer.
With a confirmed documentary credit, the confirming bank undertakes, additionally to the issuing bank, the obligation to pay the seller for the goods if the seller has presented documentary credit complying documents to the bank.
- With the confirmed documentary credit the seller is guaranteed by the confirming bank that if the documents submitted to the bank comply with the terms and conditions of the documentary credit, the confirming bank is obligated to pay the seller. This means that confirming a documentary credit also reduces the payment risk of the buyer’s bank (the issuing bank).
- Confirmed documentary credit is used when the seller has reservations about the buyer’s bank or the country of origin of the buyer’s bank.
- Confirmation of a documentary credit is prerequisite for acquiring financing (discounting of accounts receivable).
Transferable documentary credit allows an intermediary who is the first beneficiary of the documentary credit to transfer the documentary credit in favour of the supplier (i.e. the seller who is the second beneficiary of the documentary credit) with the bank’s approval. This enables the intermediary to buy the goods from the supplier, who might be the manufacturer, and then use the same documentary credit to sell the goods to the buyer. The intermediary transfers the right to receive payment under the documentary credit up to the transferred amount by transferring the documentary credit to the second beneficiary.
- The supplier has to comply with the terms and conditions in the documentary credit set by the buyer and must submit the required documents.
- Upon receipt of the documentation by the transferring bank, the intermediary only substitutes the supplier's invoice and the bill of exchange, if the bill of exchange is required under the documentary credit. This means that the main task of the intermediary is to agree upon similar terms and conditions other than price with both its buyer and the seller, as it is the second beneficiary of the documentary credit, the seller, who must meet the terms set by the buyer in the documentary credit.
The documentary credit is transferred in its original form. When the documentary credit is transferred, the first beneficiary of the documentary credit (the intermediary) may only change the following terms:
- the amount of the documentary credit;
- the unit price of the goods;
- the expiry date of the documentary credit;
- the latest shipment date for the goods;
- the presentation period of the documents.
All these values can be reduced and the deadlines shortened, but the intermediary may also increase the insurance amount to ensure that the insurance complies with the terms and conditions of the original documentary credit.
Advantages of transferable documentary credit for the intermediary
- Gives opportunity to intermediate large trade transactions without having to use own funds or apply for credit decision.
- If the terms and conditions of the documentary credit allow partial shipments, the documentary credit can be transferred to several second beneficiaries.
Back-to-back documentary credit is used when a transferable documentary credit cannot or may not be used for any reason. Back-to-back documentary credit is issued by the bank at the request of the intermediary in favour of the supplier. The documentary credit issued by the intermediary’s bank is based on the documentary credit previously issued in favour of the intermediary.
- In legal terms, these are two independent documentary credits, so in contrast to the transferable documentary credit, the bank may require the intermediary to provide additional collateral for issuing a back-to-back documentary credit because the initial documentary credit is not considered to offer 100% collateral for the bank.
- However, the use of back-to-back documentary credit allows the intermediary to avoid direct contact between the buyer and the seller.
A revolving documentary credit is used for paying for regular deliveries over a longer period of time.The buyer asks the bank to issue a documentary credit with a ‘revolving clause’, which allows the seller to submit documents to the bank under the same documentary credit after a time set in the documentary credit, without the buyer having to make any amendments.
A stand-by documentary credit is very similar to a bank guarantee and is actually a guarantee instrument.
- With a stand-by documentary credit, the buyer pays for the goods or services outside the documentary credit. The seller only uses the documentary credit by presenting the required documents to the bank if the buyer fails to pay correctly.
- The only documents required under a stand-by documentary credit are usually a copy of the invoice issued to the buyer and a written claim from the seller to the bank stating that the buyer has not fulfilled its contractual payment obligations.
One of the advantages of a stand-by documentary credit over a bank guarantee is that stand-by documentary credits are handled in a similar way to other types of documentary credits under the procedures of the Uniform Customs and Practice for Documentary Credits (UCP 600) issued by the International Chamber of Commerce. This means that under a stand-by documentary credit the bank only examines whether the documents submitted comply with the terms and conditions of the stand-by documentary credit and does not observe the actual transaction or fullfilment of the underlying contract.
|Import documentary credits|
|Drafting or amending a sample documentary credit
(to be refunded from the issuing fee during settlement of accounts)
|Issuing fee||0.2 % of the value of the documentary credit, min 125 €|
|Irrevocability fee (risk premium) for each 3-month period in the term of validity of the documentary credit||By agreement, min 40 € per 3 months|
|Extension of the payment deadline||By agreement, min 25 € per month|
|Fee for document handling, except for the first set of documents||50 €|
|Fee for amending a documentary credit||65 €|
|Handling of incorrect documents||90 € (paid by the beneficiary of the documentary credit)|
|Postage and telecommunication fees||Actual costs, min 10 €|
|Export documentary credits|
|Drafting or amending a sample documentary credit (to be refunded from the issuing fee during settlement of accounts)||65 €|
|Notification of the issuing of a documentary credit||65 €|
|Extension of the payment deadline||Based on the bank and country risk level|
|Handling of documents presented under the documentary credit||0.1 % of the value of the invoice, min 65 €|
|Confirmation fee||Based on the bank and country risk level|
|Discounting fee||Based on the bank and country risk level
+ base interest rate + handling fee 55 €
|Fee for notification of amendments to provisions||65 €|
|Transfer fee||0.25 % of the value of the documentary credit, min 65 €|
|Sending a SWIFT message||10 €|
|Postage fees||Actual costs|