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Documentary Letter of Credit
A documentary letter of credit (L/C) is a trade finance instrument which provides protection for both the importer and exporter. It is very useful in situations where it is not possible for the importer and exporter to know each other well enough to deal on a less secure basis, such as open account or documentary collection. The parties to the transaction may also have concerns about the political or financial situation in the other country.
The importer wants to know that the goods have been shipped as ordered and within the agreed timeframe before they pay for them. The exporter wants to be re-assured as to the security of the payment due to them without relying on the willingness or ability of the importer to pay, or worrying about political or legal issues in the importer’s country.
A letter of credit provides a practical solution. It is a conditional commitment by a bank (issuing bank), given to the exporter at the request and instruction of the importer. The L/C commits the issuing bank to pay a given sum of money within a given timeframe, on presentation of correct documentation.
The process flows like this:
• The exporter and importer agree in their contract that payment will be by letter of credit.
• The importer instructs its bank (the issuing bank) to issue an L/C in favour of the exporter. Once the bank has agreed to this, it becomes an obligation of the bank, even if the importer were to become insolvent or otherwise renege on its commitments to the bank. (This is why the L/C re-assures the exporter so much).
• The issuing bank then sends the letter of credit to a bank in the exporter’s country (the advising or confirming bank). The issuing bank instructs the advising bank to pay the exporter (beneficiary) once the issuing bank confirms receipt of specified documents such as shipping documents.
• If there are any discrepancies between what was agreed between the importer and exporter and what is in the L/C, then the exporter will contact the importer to request and amendment.
• Once issued, an L/C cannot be amended without the consent of all parties.
• If requested, the advising bank may add their own payment undertaking to the L/C. This makes it even more valuable, but would also incur extra costs.
• The advising bank will check the relevant documents and forward them to the issuing bank. The issuing bank will check the documents again.
• Payment is made from the issuing bank to the advising bank at the agreed time, and the importers account is debited. The advising bank can then credit the exporter’s account.
• Then, all documents, such as those transferring title of the goods and those entitling the importer to claim the shipment, are forwarded to the importer.
Click this link for a more comprehensive explanation of a
documentary letter of credit
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