About Documentary Payments 

Documentary payments significantly reduce the risk involved in foreign trade transactions. For exporters, they help ensure payment on time and in full. For importers, they help ensure that the exporter has actually shipped the goods for which they are paying.

Documentary payments reduce risk by requiring shipping documents as proof of the transaction. Documentary payments reduce the risk for exporters because importers cannot collect the documents they need to retrieve the goods (documents like bills of lading) until they pay for the goods. They reduce the risk for importers because they do not pay for the goods unless the exporter has provided all of the documents proving that the agreed-upon goods were shipped under the agreed-upon conditions.

One of the most common types of documentary payments is the letter of credit.

Letters of Credit

A letter of credit is a legally negotiable document issued by a bank at the request of an importer. The letter of credit ensures the financial ability of the importer to pay for the goods by substituting the credit of a bank for the credit of the importer.

There are several types of letters of credit differing according to their use and the number of banks involved. Outlined below are the business flow and the goods and value flow for a common foreign trade procedure using a letter of credit.

Business Flow in a Letter of Credit Transaction

  1. The importer sends a purchase order to the exporter.
  2. The purchase order is a promise to contract purchase of the specified goods under certain conditions.

  3. After receiving the purchase order, the exporter issues an order confirmation.
  4. The order confirmation is a promise to sell and deliver the goods according to the agreed-upon conditions including payment conditions.

  5. The importer, in compliance with the payment conditions the exporter requested, opens a letter of credit at the bank of its choice. This bank is called the opening or issuing bank.
  6. The order confirmation and the purchase order are the basis of the letter of credit. The terms and conditions between the bank and the importer are based on the importer’s credit standing.

  7. After approving the request for the letter of credit, the opening bank can contact its branch or affiliate (called the advising bank) in the exporter’s country to establish and confirm the letter of credit on behalf of the exporter.
  8. The letter of credit itself is usually sent through a telex with a set of identification codes that confirm its authenticity.

  9. The advising bank authenticates the letter of credit and sends it to the exporter by registered mail.

The letter of credit has been formally established, confirming the ability of the importer to pay for the goods. The exporter now ships the goods.

Goods and Value Flow in a Letter of Credit Transaction

  1. The exporter ships the goods to the importer as the letter of credit’s terms require.
  2. Usually the letter of credit specifies shipping details including the mode of transportation, loading and unloading ports, merchandise packaging, and insurance.

  3. After shipping the goods, the exporter gives the negotiating bank the valid letter of credit and the required shipping documents.
  4. The exporter can select a negotiating bank or use the advising bank as the negotiating bank.

  5. The negotiating bank examines the validity of the shipping documents for any discrepancies.
  6. – If the documents contain discrepancies, the negotiating bank may refuse to accept the documents for negotiation. The exporter may then either apply for an amendment to the letter of credit to allow the discrepancies or submit a letter of guarantee to the negotiating bank. The letter of guarantee states that the exporter is liable if the importer refuses to accept the documents due to the discrepancies.

    – If documents do not contain discrepancies, the negotiating bank accepts the documents and pays the exporter the contracted amount for the goods. Banking charges may be deducted from this payment depending on the letter of credit’s terms.

  7. The opening bank reimburses the negotiating bank for the amount it paid the exporter. In exchange, it receives the shipping documents from the negotiating bank.
  8. The negotiating bank may be entitled to collect bank changes from the opening bank depending on the letter of credit’s terms.

  9. The opening bank negotiates with the importer for payment in exchange for the shipping documents.
  10. The payment between the importer and the opening bank depends on the terms of their agreement. Some banks require 75% of the order value in advance and the remaining 25% when the shipping documents arrive.

  11. After receiving the valid shipping documents from the opening bank, the importer presents the bill of lading to the shipping company and claims the goods.

The importer uses other shipping documents like commercial invoices, packing lists, and certificates of origin during customs clearing.