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.