One of the main concerns facing exporters is how to eliminate commercial risk. In other words, how can they be certain they will effectively be paid for a sales operation carried out abroad.
A documentary credit or letter of credit is a method of payment that irrevocably guarantees collection of said payment, provided the requirements set out in the terms and conditions are fulfilled with regard to format and timeframe.
As with all Foreign Trade operations, the letter of credit is issued through the SWIFT platform, which is an international banking interconnection system that guarantees total security in transactions.
The different parties involved in a letter of credit or documentary credit are:
- Ordering Party: the ordering party is always the importer, who must have a risk facility in place with their own bank in order to issue the documentary credit.
- Beneficiary: the beneficiary is always the exporter
- Ordering Bank: the bank of the ordering party
- Beneficiary Bank: the bank of the exporter, also known as the Advising Bank.
- Receiving Bank: the bank that receives the documentary credit, which might be the beneficiary bank or another intermediate bank in the event that the issuing and beneficiary banks do not have an agreement in place.
- Confirming bank: the issuing bank requests that a confirming bank adds its confirmation to the documentary credit operation. It is usually the exporter’s bank.
- Reimbursing bank: the correspondent bank of the issuing bank. In other words, the bank through which funds are channelled.
The main types of documentary or letters of credit are as follows:
- Confirmed: all documentary credits guarantee collection of payment owing to the exporter. This guarantee is given by the issuing bank. In other words, said bank will always pay the exporter provided the documents presented by said exporter comply with requirements. If the credit is also confirmed, there is a second bank (normally the exporter’s bank) that adds an additional guarantee, which comes into effect when the issuing bank breaches its commitment to pay.
- Transferrable: The terms and conditions of a documentary credit must expressly state whether it is transferrable or not. It will be transferred when, having been received by the exporter acting as an intermediary in an operation, it is then sent onto a third party.
- Stand by: these are documentary credits in which the supplier is guaranteed so that it only has to present documents in the event of non-payment by the customer. In other words, payment will be made outside the bounds of the documentary credit, and the credit will only be executed if payment is not made within the established timeframe.
These are the customs and practices set out by the International Chamber of Commerce, establishing a set of international rules for the interpretation of commercial terms pertaining to purchase and sales contracts, limiting the rights and obligations of the parties in relation to the provision of goods.
The last revision dates from 2010.
The most frequently used Incoterms ® are: FOB (Free on board), CIF (Cost, Insurance and Freight and CFR(Cost and freight).
Before a Documentary or Letter of Credit is issued, the importer and exporter must sit down and negotiate each of the points to be included in the credit terms and conditions.
The exporter must agree the following points with its customer so that the latter can then convey them to its financial entity or bank when issuing the documentary credit:
- Type of documentary credit: Confirmed? Transferrable?
- Method of payment: on demand or deferred
- Description of goods
- Expiry date: this is the deadline for the presentation of documents
- Shipment deadline
- Documents required: invoices, packing list, transport document, certificate of origin,...
- Transfers: the terms and conditions must specify whether the goods are allowed to be transferred from one ship to another, for example, or not.
- Partial shipment: will all the goods be loaded at the same time, or can several loads be shipped on different dates?
- Tolerance: this indicates whether the invoice must reflect the exact amount of the documentary credit or whether variations either side are tolerated. Normally, tolerance, if permitted, is usually 10%.
- Place of origin and destination of the goods
- Loading and unloading port for the goods
- Incoterm ®: the responsibilities of each party, in other words, who pays the freight charges, for insuring the goods,...
- Beneficiary’s bank (advising bank): the exporter’s bank.
- Banking charges: the terms and conditions of the documentary credit must specify who is responsible for the banking charges applied by the issuing bank, the receiving bank, the confirming bank,...
When you receive the documentary credit, you must check all the terms you need to comply with and that they are as previously agreed with the importer. Bear in mind that guaranteed collection depends on your presenting the correct documents.
Once the documentary credit has been issued, all the terms can be modified with the exception of the receiving bank of the documentary credit.
Sometimes, unforeseen circumstances arise, such as delays in shipment, meaning that the terms and conditions might have to be modified.
When this happens, the importer will give instructions to their bank to change the conditions of the credit by issuing a Swift modification message.
A documentary or letter of credit operates as follows:
- Contract of purchase/sale: the starting point is for importer and exporter to negotiate all terms and conditions.
- Request: once the pertinent agreements have been reached, the importer then goes to their bank to request the issuance of a documentary credit.
- Issuance of the documentary credit: the importer’s bank will issue the operation by means of a Swift message.
- Notification of the documentary credit: the receiving bank will notify its customer that it has received the documentary credit. If the importer’s bank and the exporter’s bank do not have a code, the issuing bank will issue the operation to an intermediary bank, which will be responsible for notifying the exporter’s bank.
- Shipment of goods
- Presentation of documents by the exporter: remember, provided the documents presented are correct, collection of payment is guaranteed.
- Sending of documents: the exporter’s bank will send the documents to the issuing bank.
- Sending of funds: by the issuing bank on the agreed date, provided the documents are correct or, if there were discrepancies, the importer has lifted them.
- Crediting of funds to the exporter and debiting from the importer’s account if payment is on demand. If payment is deferred, the payment commitment will be maintained on the agreed date.
- Provision of documents to the importer to collect the goods at the agreed destination: if there were any discrepancies, in order for documents to be provided to the importer, the latter must lift them.
- Collection of goods by importer.
If the documents you present do not comply with the documentary credit terms and conditions, collection of payment will be contingent upon the importer lifting any discrepancies, in other words, the collection guarantee disappears.
Once the importer has lifted any discrepancies, the collection guarantee comes back into effect.
Discrepancies might be:
- Shipment after deadline
- Documents presented after deadline
- The amount of the invoice exceeds the amount authorised in the documentary credit.
- Incoherent documents.