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
The purchase order is a promise to contract purchase of the specified goods under certain conditions.
The order confirmation is a promise to sell and deliver the goods according to the agreed-upon conditions including payment conditions.
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.
The letter of credit itself is usually sent through a telex with a set of identification codes that confirm its authenticity.
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
Usually the letter of credit specifies shipping details including the mode of transportation, loading and unloading ports, merchandise packaging, and insurance.
The exporter can select a negotiating bank or use the advising bank as the negotiating bank.
– 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.
The negotiating bank may be entitled to collect bank changes from the opening bank depending on the letter of credit’s terms.
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.
The importer uses other shipping documents like commercial invoices, packing lists, and certificates of origin during customs clearing.