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What is a documentary letter of credit and how do they assist international trade?

International trade calls for understanding and agreements between importers and exporters.  Contracts between the two parties may call for payment under a letter of credit.  The letter of credit is commonly referred to as a documentary letter of credit.  Documentary letters of credit are documents which allow importers/buyers to offer secure terms of payment to exporters or sellers involving one or more banks.

Documentary letters of credit are not goods – they are documents in which both parties deal and come to an understanding regarding their transaction.  They are a payment undertakings given by a bank to the seller and are issued on behalf of the applicant i.e. the buyer these documents assist international trade as mechanisms which help in shifting the risk in the transaction from the actual buyer to a bank.

The parties concerned are the Buyer who is the Applicant and the Seller who is the Beneficiary. The Bank which issues the documentary letter of credit is referred to as the Issuing Bank and  is usually located in the country of the Buyer. The Bank which Advises the letter of credit to the Seller is called the Advising Bank which is generally located in the country of the Seller.

Documentary letters of credit are written commitments by a bank to make payment on presentation (of the document) of a defined amount of money to a beneficiary (exporter) as per the terms and conditions outlined by the importer (applicant). The letters of credit should spell out a time limit for completion and specify which documents are required to confirm fulfillment of the transaction.

A documentary letter of credit is an additional contract concerned with credit between the applicant (importer) and the issuing bank and is separate from the original grain contract.

For any letter of credit for the credit to become a valid, operable instrument certain components are necessary:

Applicant: The party applying for the letter of credit, usually the importer.

The Issuing Bank: The bank which issues the letter of credit and undertakes the responsibility to make payment to the beneficiary, usually the exporter.

Beneficiary: The party in whose favor the letter of credit is issued, usually the exporter.

Amount: The sum of money, usually defined as a maximum amount, of the credit defined in a specific currency.

Terms: The requirements, including documents necessary for the collection of the credit.

Expiry: The last date for the beneficiary to present against the credit.

 

Letters of credit come in different forms depending on their level of risk. Revocable letters of credit (the most risky forms) permit the issuing bank (at the applicant’s request) to amend or cancel the credit at any point of time without the approval of the exporter (beneficiary). On the other hand irrevocable letters of credit contain terms and conditions which cannot be amended or changed without the express consent of all parties concerned, the issuing bank, the exporter (beneficiary) and the importer (applicant). Additionally there is a commitment by a bank other than the issuing bank to irrevocably honor the payment of the credit subject to the exporter meeting the terms and conditions of the credit.