What it means
Trade across borders faces a problem of trust. The seller does not want to ship goods to a buyer it cannot easily sue in a foreign court without being sure of payment; the buyer does not want to pay in advance for goods it has not seen from a seller it cannot easily hold to account.
A documentary credit resolves the problem by putting a bank's promise in the middle. The buyer asks its bank to issue a credit in favour of the seller, promising payment against documents, typically a commercial invoice, a transport document such as a bill of lading proving shipment, an insurance certificate, a packing list and any certificates of origin or inspection the buyer requires.
The seller ships the goods and presents the documents, usually through its own bank; if they comply, the issuing bank pays, and the buyer reimburses its bank and receives the documents, which it needs to collect the goods. The parties and their roles are fixed by convention: the applicant is the buyer who requests the credit, the issuing bank issues it and is bound by it, and the beneficiary is the seller.
The advising bank, usually in the seller's country, passes the credit to the seller and checks its authenticity. A confirming bank, if one is used, adds its own undertaking to pay, so that the seller has the promise of a bank in its own country as well as the issuing bank's; confirmation is sought where the issuing bank or its country carries risk.
A nominated bank may be authorised to pay, accept or negotiate on the issuing bank's behalf, and almost all documentary credits are issued under the International Chamber of Commerce's Uniform Customs and Practice, known as UCP 600, which sets the rules for examination of documents and the banks' obligations. Credits come in several forms: an irrevocable credit cannot be amended or cancelled without the agreement of all parties and is the norm, revocable credits being effectively obsolete.
A sight credit pays on presentation of compliant documents, while a usance or deferred payment credit pays at a set time after presentation or shipment, giving the buyer credit, and the seller can often discount the bank's acceptance to receive cash early. A standby credit is a guarantee in the form of a credit, drawn only if the buyer fails to pay by other means; transferable credits let the seller pass part of the credit to its own suppliers, back-to-back credits achieve a similar effect with two separate credits, and revolving credits cover a series of shipments.
The principle of strict compliance governs payment: the bank examines the documents against the credit's terms, and a discrepancy, such as a shipment date after the latest permitted, a description of goods that differs from the credit, a missing signature or an invoice amount above the credit, entitles the bank to refuse payment. Banks reject a large proportion of first presentations for discrepancies, and a rejected presentation converts the seller's secured payment into an unsecured one dependent on the buyer's willingness to waive the discrepancy, which the buyer may use to renegotiate the price.
Preparing documents that comply exactly with the credit is therefore the seller's most important task, so experienced exporters check the credit's terms on receipt and ask for amendments before shipping if the terms cannot be met. The costs are the issuing bank's fee, typically a percentage of the amount, confirmation, advising, handling and discrepancy fees, and the interest cost of any usance period.
Against these are set the benefits: for the seller, a bank's promise instead of a buyer's, faster and more certain payment, and the ability to finance the shipment against the credit; for the buyer, assurance that payment is made only against evidence of shipment, and often credit terms from the seller that open account would not offer. For the finance function, a documentary credit is both a risk management tool and a working capital instrument, and its terms should be negotiated with both in mind.
In practice
Real-world examples
Example 1
A commodities trader buys $2,000,000 of grain under a sight credit issued by its bank and sells it under a transferable credit to its own customer, with the two credits' documents matched so that the trader's margin is secured.
Example 2
A contractor building a plant overseas receives progress payments under a standby credit that the client's bank will honour if the client fails to pay a certified invoice within 30 days.
Example 3
A small exporter's first presentation under a credit is rejected for four discrepancies, and it engages a freight forwarder with a documentary credit checking service for its next shipment.
Think of it
Documentary credit is a bank guarantee for international trade-pay when the right documents are presented.
Formula
Calculation
Cost of a documentary credit to the buyer = Issuance fee (percentage of amount) + Amendment and handling fees
Cost to the seller = Advising fee + Confirmation fee (if confirmed) + Discrepancy fees + Discount cost on a usance credit
Discount cost on a usance credit = Amount x Discount rate x Days to maturity / 365
Expected loss on open account = Probability of non-payment x Amount (for comparison with the cost of the credit)
Worked example. An exporter agrees to sell machinery for $500,000 to a new customer overseas. The customer's bank issues an irrevocable credit at 90 days' sight, and the exporter asks its own bank to confirm it.
- Issuance fee (paid by the buyer) at 1%: $5,000
- Confirmation fee (paid by the seller) at 0.5%: $2,500; advising and handling fees $400
- On presentation of compliant documents, the confirming bank accepts to pay in 90 days; the exporter discounts the acceptance at 6% a year to receive cash immediately: discount = $500,000 x 6% x 90 / 365 = $7,397
- Net proceeds to the exporter = $500,000 minus $2,500 minus $400 minus $7,397 = $489,703, received about ten days after shipment, with no credit risk on the buyer or its bank
Comparison with open account. Had the exporter shipped on open account with 90-day terms, it would have received $500,000 in about 100 days if the customer paid on time, with the full credit risk. If the exporter assessed a 3% probability of non-payment on a new customer in that market, the expected loss would be $15,000, almost twice the $7,900 of total fees on the confirmed credit, before counting the cost of financing a 100-day receivable.Case study
Seen in the real world
This is a fictional, illustrative scenario. A manufacturer of industrial pumps won its first order from a distributor in a new market, worth $500,000, and, on its bank's advice, required payment by irrevocable documentary credit confirmed by its own bank. The sales team read the credit as a formality and the pumps were shipped, but the bank found three discrepancies on presentation. The bill of lading was dated the 17th against a latest shipment date of the 15th, because the vessel had been delayed; the invoice description omitted the model wording and proforma invoice reference that the credit required; and the insurance certificate covered 100% of the invoice value where the credit called for 110%.
Each was minor in commercial terms and none affected the goods, but the bank was entitled to refuse, and it did. The confirmed, secured payment the manufacturer had counted on became a request to the distributor to waive the discrepancies. The distributor, whose own market had softened in the six weeks since the order, agreed only in return for a 6% reduction in price, $30,000, and the manufacturer accepted because finding another buyer for pumps sitting in a foreign port would probably have cost more. The distributor paid $470,000 against the amended documents, on time.
The credit should have been checked line by line on receipt, with the tight shipment date prompting a request for amendment before shipping. The manufacturer introduced a checklist and used its bank's document preparation service at $250 a presentation for its next three credits, after which none of the next twelve presentations was rejected. The finance director's note observed that the $30,000 had been the price of not understanding what "compliant" meant.
Watch out
Common mistakes
- Treating the credit as a formality and shipping without checking that every term can be met; a discrepancy turns a bank's promise into a request for the buyer's goodwill.
- Preparing documents from the seller's own templates rather than from the exact wording of the credit, so that descriptions, amounts and dates do not match.
- Assuming the bank will pay if the goods are right; banks deal only in documents, and will refuse compliant goods with discrepant documents and pay for defective goods with compliant ones.
Questions
People also ask
What is the difference between a documentary credit and a bank guarantee?
A documentary credit is the primary means of payment, drawn against documents in the ordinary course of the transaction. A guarantee (or a standby credit) is drawn only if the buyer defaults on payment by other means. Both are bank undertakings, but a credit is expected to be used and a guarantee is not.
What is a confirmed credit?
One to which a second bank, usually in the seller's country, has added its own undertaking to pay, so that the seller is protected against the failure of the issuing bank or restrictions in its country. Confirmation costs a fee and is sought where the issuing bank or its jurisdiction carries risk.
Who bears the cost of a documentary credit?
By default the buyer pays the issuing bank's fees and the seller pays those of banks on its side, but the allocation is negotiable and is often specified in the sales contract. The seller may price the costs into the goods.
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