Documentary letters of credit
Processing and securing payments in international trade with a commitment provided by one or more banks
Documentary letters of credit:
Documentary letters of credit offer the highest level of protection when payments are made in international trade. When applied correctly, documentary letters of credit protect importers and exporters from risk and balance the interests of both parties. This is particularly true when it comes to new business contacts. Behind every documentary letter of credit stands a bank (or several banks), promising to make payment to an exporter as soon as that exporter has fulfilled obligations that have previously been meticulously agreed on in a contract. Documentary letters of credit not only provide protection, they also fulfil a financing function as exporters can grant their customers generous terms of credit without having to wait too long for their money – by turning their claim into liquidity before the letter of credit is due.
What is a documentary letter of credit?
Documentary letters of credit are important tools for processing, protecting and financing international trade. They eliminate certain risks for the parties to a trade: a bank (the "issuing bank" or "opening bank") contractually agrees to pay the seller ("exporter") a certain amount in a certain currency on a certain date on behalf of, for account of and in accordance with the instructions from the buyer ("importer"), in return for the delivery of certain documents matching the specifications set out in the letter of credit. Buyers often use the term "import letter of credit", reflecting their point of view, while sellers refer to these instruments as "export letters of credit".
How does a documentary letter of credit work?
- Importer and exporter agree on the delivery of machinery. Because it is the first time the two parties are doing business together, they agree on the following terms of payment: the importer is to open a letter of credit with their principal bank – the "issuing" or "opening" bank – for the benefit of the exporter and available by sight payment with Commerzbank. With the opening of the letter of credit, the issuing bank makes a non-accessory undertaking to pay.
- The exporter reviews the letter of credit and then ships the machinery to the importer.
- The exporter presents the documents required as per the letter of credit to their advising bank – Commerzbank – that checks these documents for compliance with the terms and conditions of the letter of credit.
- Commerzbank provides the complying documents to the issuing bank.
- The issuing bank checks the documents and informs the importer.
- Once the issuing bank has obtained payment from the importer, it releases the documents to the importer, who is then able to dispose of the machinery.
- The issuing bank passes the payment on to Commerzbank.
- The exporter receives payment from Commerzbank.
What types of documentary letters of credit are there?
Confirmed and unconfirmed letters of credit
In the case of unconfirmed letters of credit, the buyer's issuing bank assumes the obligation to make the payment, while the seller's advising bank does not incur any obligation. In the case of confirmed letters of credit, the advising bank enters into a payment obligation of its own on behalf of – or on authorisation by – the issuing bank, providing the seller with extra protection. Yet another type is a letter of credit with a silent confirmation. This means that the advising bank enters into an irrevocable payment obligation on the request of the buyer, but without the issuing bank or the issuing bank's principal being aware of this commitment.
Availability of letters of credit
Every letter of credit must specify the conditions that must be fulfilled for the letter of credit to become available (meaning that it can be drawn upon). There are various options:
- Sight letter of credit
The bank releases payment to the seller as soon as the complying documents are presented, i.e. without delay.
- Usance letter of credit
Usance letters of credit, also known as deferred payment letters of credit, differ from sight letters of credit in that the seller does not receive the equivalent of the complying documents presented without delay, but at a later, specified date (e.g. 60 days after bill of lading date).
- Acceptance letter of credit
The issuing bank is required to accept a bill of exchange, drawn by the beneficiary, when the complying documents are presented. The buyer acknowledges the payment request with their signature; this acknowledgement is binding. The seller receives payment on the due date of the bill of exchange.
Negotiation means the purchase of drafts and/or documents under a complying presentation. If a letter of credit becomes available by negotiation, the negotiating bank – acting on behalf of the issuing bank – can pay the seller before reimbursement is due.
Advantages of using a letter of credit
- Exporters receive a non-accessory and conditional promise from a bank that payment will be made. This serves to ensure that the goods delivered will be paid once the complying documents have been presented, irrespective of the importer's interests.
- The bank's irrevocable promise to pay eliminates the risk that the goods might be rejected or that the importer be unwilling or unable to pay. In the case of a confirmed letter of credit, the promise to pay is provided by two banks.
- Letters of credit can be used for financing purposes.
- Globally accepted guidelines provide legal certainty.
- Payment will only be made upon presentation of complying documents.
- A bank's promise to pay strengthens the importer's position in negotiations
Accommodating importer and exporter priorities
Eliminating country risk: confirmed export letter of credit
If the economic or political stability of the target country is in doubt, a promise to pay provided by a bank located in that country may prove worthless. In such cases, a confirmed letter of credit may be a good idea, with both the importer's bank and the exporter's bank making a payment commitment.
Strong value chains:
immediate payment of import letters of credit
Commerzbank can open a letter of credit for the importer. If the importer client opens a usance letter of credit, the amount specified will be paid to the supplier weeks or months after the documents have been presented and accepted. Under certain circumstances, Commerzbank may be able to offer that payment to the exporter will be made immediately, but the importer will not have to pay the Bank until after the usance period has passed.