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Discousion of Documentary credit/Letter of credit (L/Cs) Operation

Updated on May 08, 2011

Documentary credit/Letter of credit (L/Cs)

Documentary Credit is an assurance of payment by the bank. It is an arrangement under which the bank at the request of the buyer or on its own undertakes to make payment to the seller provided specified documents are submitted.

Documentary Credit is an arrangement whereby a bank (issuing bank) acting at the request and on the instruction of a customer (the applicant) or on its own behalf undertakes to make payment to or to the order of a third party (the beneficiary) or to accept and pay bills of exchange (draft) drawn by the beneficiary, or authorize another bank to negotiate against stipulated documents provided the terms and conditions to the credit are complied. Thus, Documentary Credits are akin to bank guarantees. In popular language, they are known as Letters of Credit (L/Cs). Bank guarantees are, however, issued to cover situation of non-performance whereas Documentary Credits are issued on behalf of the buyer to cover situation of performance, i.e., the issuing bank agrees to make payment to the beneficiary once he surrenders the requisite complying documents. However, the term Documentary Credit has of late been extended to cover the situation of non-performance too. Documentary Credits have gained wider acceptance in international trade for they try to safeguard the interest of both the buyer and the seller by reducing their risks. Thus, Documentary Credit offers a unique and universally used method of achieving a commercially acceptable arrangement by providing for payment to be made against complying documents that represent the goods and making possible the transfer of those goods.

Bank as a party of Documentary credit

Parties to the documentary credit may be an issuing bank, an advising bank, a confirming bank, a reimbursing bank or a negotiating bank.

Ø      Issuing Bank: The Issuing Bank or the Opening Bank is one which issues the credit, i.e., undertakes, independent of the undertaking of the applicant, to make payment provided the terms and conditions of the credit have been complied with. The payment may be at sight if the credit provides for sight payment or at maturity dates if the credit provides for deferred payment. Especially the issuing bank should satisfy himself on the credit worthiness of the applicant. The credit application must be in accordance with UCP 500 and in a workable format.

Ø      Advising Bank: The Advising Bank advises the credit to the beneficiary thereby authenticating the genuineness of the credit. The advising bank is normally situated in the country/place of the beneficiary.

 Ø      Confirming Bank: A Confirming Bank is one which adds its guarantee to the credit opened by another bank, thereby, undertaking the responsibility of payment/negotiation/acceptance under the credit in addition to that of the issuing bank. A confirming bank normally does so if requested by the issuing bank and it is normally the advising bank.

Ø      Negotiating Bank: A Negotiating Bank is the bank nominated or authorized by the issuing bank to pay, to incur a deferred payment liability, to accept drafts or to negotiate the credit.

Ø      Reimbursing Bank: A Reimbursing Bank is the bank authorized to honor the reimbursement claims in settlement of negotiation/acceptance/ payment lodged with it by the negotiating bank or accepting bank. It is normally the bank with which the issuing bank has account from which payment is to be made. 

Types of documentary letter of credit:

Documentary credits are basically two types:

I. Revocable

II. Irrevocable

I. Revocable credit: This type of credit can be revoked or cancel at any time without the consent of, or notice of the beneficiary. In case of seller (beneficiary), revocable credit involves risk, as the credit may be amended or cancelled while the goods are in transit and before the documents are presented, or, although presented, before payment has been made. In modern banking, the use of revocable credit is not widely spread.

II. Irrevocable Credit: The irrevocable credit is a commonly used type of documentary credit. The credit which can not be revoked, varied or change / amended without the consent of all parties- buyer, seller, issuing bank, and confirming bank irrevocable credit gives the seller grater assurance of payments, but he remains dependent on an undertaking of a foreign bank. Irrevocable credit may be confirmed or unconfirmed.

Types of documentary credits according to payment methods:

Ø Sight Credit

Ø Deferred payment credit

Ø Sight Payment:The payment is made as soon as documents shown to the issuing Bank and payment received from importer. Instruction is given to reimbursing bank to give payment.

Ø Deferred Payment:The payment of this kind of L/C is made after 30, 60, 90, 120 or 180 days soon as documents shown to the issuing Bank. The credit with deferred payment differs only slightly in its effect on the beneficiary from the credit with time draft.

Special Types of Documentary Credit

1. Revolving:

A revolving credit is one where, under the terms and conditions thereof, the amount of the credit is renewed or reinstated without specific amendment to the credit being needed.

Revocable credit may be revocable or irrevocable. It can revolve in relation to time or value.

2. Back to Back Credit:

One credit backs another. It may so happen that the beneficiary / seller of an L/C is unable to supply the goods direct as specified in the credit as a result of which he need to purchase the same and make payment to another supplier by opening a second letter of credit. In this case, the second credit called a "Back to back credit". This concept involve opening of second credit on the strength of first credit, i.e. mother L/C opened by foreign importers. Under back to back concept, the mother L/C stands as security for opening of second credit.

3. Transferable Credit:

A transferable credit is one which can be transferred by the original beneficiary to one or more parties. In transferable credit, the original beneficiary becomes the middleman and transferee becomes the actual supplier of goods. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and thus wishes to transfer part, or all, of his rights and obligations to the actual supplier as second beneficiary.

4. Red Clause Credit:

A Red clause credit is a credit with a special clause incorporated into it that authorized the advising bank or confirming bank to make advances to the beneficiary before presentation of documents.

5. Green Clause credit

A green clause credit is a credit with a special clause incorporated into it that which not only authorizes the advising bank to grant pre-shipment advances but also storage cost for storing the goods prior to shipment.

6. Standby Letter of Credit:

The standby credit is very similar in the nature to a guarantee. The beneficiary can claim payment in the event that the principal does not comply with its obligations to the beneficiary. Payment can usually be realized against presentation of a sight draft and written statement that the principal has failed to fulfill his obligation.

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