Documentary credits are one of the oldest, most sophisticated, and safest payment instruments used in international trade. Despite the fact that their demise has been anticipated for some time, they are still a core component for advancing global trade.
Despite certain breakthroughs in trade digitalization as well as a shift towards open account trade in some markets, documentary credits continue to be important payment and financing instruments.
Documentary credits as risk mitigants and financing tools
Documentary credits serve as effective tools for the mitigation of buyer risk of non-payment. This risk is replaced by the payment undertaking of a bank (or banks) and the documentary credit provides payment against documents that comply with the credit’s terms and conditions. A payment obligation from an independent third party (i.e., a well regulated and robust financial institution) will always be needed and is only conditional on transparent documentary compliance.
Needless to say, documentary credit is not only a payment instrument. It can also be used as a versatile financing tool; it can support pre-shipment and post-shipment finance.
Despite this, documentary credit users experience many inconveniences in practice. Problems tend to arise around the complexity of documents used, but also due to the often ambiguous, or even conflicting and incorrect, terms and conditions of the credits themselves. How can this be addressed and remedied? The detail is key, and in this article, I will primarily focus on the main aspects which importers and their bankers should carefully consider when using documentary credits. The following article will also offer guidance for exporters and their bankers.
Documentary Credits – Importer and its Bank Perspective
Understanding the different parties, instruments and their dynamics
The importer, (in this case, the credit applicant), as well as its bank, should understand that despite the credit being legally independent of the underlying contract of sale, it operates in a broader environment and
requires the presentation of documents that also serve vital purposes under other contracts. It is important to understand that these documents all play their separate unique roles under various contracts and relationships.
From the importer’s and also exporter’s perspective, (i.e., the beneficiary of the credit), the credit is the realization of the chosen payment condition stipulated in their contract. The credit should comply with the agreed payment conditions outlined; it is the method of how the importer pays for the goods. If the credit does not comply with the contract’s conditions, it might constitute a breach of them, or possibly require an amendment. To avoid any significant issues, the importer is advised to consult its bank regarding the payment condition before the underlying contract is concluded unless it is already deeply knowledgeable of this aspect.
It goes without saying that the importer would want a documentary credit to be paid or a deferred payment commitment made only if the exporter fulfills its relevant contractual obligations, especially regarding the delivery of the goods. However, from a bank’s perspective, its sole concern centers around whether or not a complying presentation has been made.
The contracting parties should carefully determine their obligations, and how, if at all, their fulfillment is to be demonstrated by the presentation of relevant documents. These specific documents should be specified
in the documentary credit. The conditions and necessary documentary evidence also need to be in conformity, e.g. the chosen delivery term and the required documents. For many contract conditions, it may be difficult or nearly impossible to identify a document that would exactly evidence the fulfillment of a specific condition. For example, which documents the best show that goods have been delivered to the place of destination and are ready for unloading when it is the delivery obligation of the exporter as in the case of DAP Incoterm 2020?
From a documentary credit perspective, it is all about determining which obligations are to be evidenced by which documents; both in the underlying contract and within the documentary credit. These documents are
usually among the following: commercial invoice, transport document, certificate of origin, and possibly an insurance document and inspection (quality) certificate.
Both the importer and its banker (as well as the exporter and its banker) should understand the roles of documents in international trade, as well as their limitations.
Knowledge of UCP 600 rules
The importer needs to correctly and sufficiently specify the corresponding details of the documents required by the credit. In this regard, it might be wise to seek professional advice from an experienced banker.
The importer should be aware of UCP 600, a set of international rules which govern documentary credits. UCP 600 has more specific requirements regarding the examination of commercial invoices, transport, and insurance documents. Even with these documents, it is important to specify additional details for the documentary credit. ISBP 745, a complimentary publication that further elaborates on international standard banking practices for the examination of documents under documentary credits, includes general provisions regarding the examination of all documents, as well as specific provisions on drafts, commercial invoices, transport and insurance documents, and guidance for the examination of packing and weight lists, certificates of origin, certificates of analysis, inspection, phytosanitary, quantity, quality, and other certificates. Yet, it might still be needed to specify clearly requested content and designate the issuer of
Watch out – there are limits!
The importer should not only appreciate the advantageous features of documentary credits but also their limitations. For instance, banks are not liable or responsible for the form, sufficiency, accuracy, genuineness, falsification or legal effect of any document. The importer should in any case conduct adequate due diligence on its trade partner. Documents are susceptible to falsification so one should not underestimate the risk of fraud and abuse.
The documentary credit is not only a secured payment instrument but it can also be used as a financing tool. One can argue that it provides some form of financing to the importer even if the credit is available by sight payment unless the issuing bank is fully secured by cash collateral. If the issuing bank provides a credit line to the importer, secured by any other means than cash, then the importer benefits from a cash flow and working capital perspective.
Nevertheless, the importer often needs additional financing, i.e. the ability to finance its cash conversion cycle. An importer might ask its bank for an (import) loan, or possibly negotiate a deferred payment credit with the exporter instead. More likely, the importer would pay the cost of the financing in any case, either directly (to its bank for a loan) or indirectly (for the deferred period which would result in a higher price for the imported goods).
So crucial questions for an importer would be: How much would this cost? What is the cheapest method for financing my trade? How much would I pay in each case? What would be cheaper: a sight L/C and a local
loan or a deferred payment L/C for an increased price? If the importer is based in a high-interest rate environment, but the exporter enjoys lower financial costs in his location, most probably the financing effectively provided by the deferred payment L/C would be (sometimes significantly) cheaper! Banks might even include the financing into the credit terms and conditions by means of so-called post-financing or UPAS (“usance credit payable at sight”).
*Pavel Andrle is an international trainer and consultant. He is founder, owner, and managing director of Trade Finance Consulting, s.r.o., www.tradefinanceconsulting.com. He is the author of recently published practical guide Documentary Credits in Practice – see https://www.tradefinanceconsulting.com/publications/.