Documentary credit or letter of credit (LC) is the bank's obligation to pay seller of goods or services a certain amount of money for timely submission of the relevant documents confirming the shipment of goods or performance of contractual services. Documentary letter of credit allows to make the payment immediately after submission of the documents ("in demand") or on a specified future date after shipment (the "Term"). Uniform Customs and Practice for Documentary Credits, ICC Publication number 600, 2007 Edition Paris, are the basis of regulatory documents used in letters of credit.
Payment mechanism:
1. Two parties sign purchase and sale agreement, where form of payment is irrevocable documentary letter of credit (Letter of credit).
2. Importer (buyer) applies to the issuing bank to open letter of credit in the amount agreed for the goods delivery.
3. Issuing bank opens letter of credit in the seller's (exporter) favour, which enters the beneficiary's bank (exporter's bank) in the form of SWIFT messages.
4. The exporter's bank (bank of the beneficiary) informs the exporter that letter of credit is issued in his favour.
5. Exporter ships the goods, prepares necessary documents and send them to the bank in order to provide the designated bank.
6. Designated bank checks the documents; in the case of matching documents, terms and conditions of the LC, it makes payment to the exporter in the amount of documents (according to the actual shipment).
7. Designated bank sends the documents to the importer's bank for onward transmission to the importer.
The importer (buyer) has assurance that bank does not enroll payment for the account until it will receive shipping documents in accordance with the LC terms and it is satisfied that the received documents satisfy requirements of the importer. Banks refuse to pay for documents at the importer expense, if the documents on the goods do not meet terms of the LC, protecting the importer's interests. Seller can be confident of receiving payment, but he will give the bank the documents matching the LC. Seller receives against shipping documents required in the letter of credit provided, immediate payment (if the Credit provides for the terms of payment "on demand").
Benefits of using letters of credit to the exporter (seller):
Payment is guaranteed by the bank-issuer in the event of submitting relevant documents to the bank. It is useful when you are not sure of the creditworthiness of the customer or if your trade relationship was not established.
Once an actual letter of credit received, the buyer can not cancel or change it without the permission of the seller. Seller may, therefore, produce, or arrange for deliveries of goods without fear that the order will be canceled later.
There will be no any confusion as to what documents must be submitted by the buyer as all necessary documents required for the seller and country authorities, listed in the letter of credit;
You may offer a more competitive trading conditions, such as conditions of payment 60 days after delivery, but not immediately, this method of payment is more reliable;
Benefits for the importer (buyer):
Pointing to the LC requirements to the documents, the buyer can be assured that payment will be made only in the event that will feature all of the documents required by the LC;
The LC may be specified as the last date of shipment, at which the goods are to be shipped, so controlled delivery schedule;
Necessary documents for the provision of quality and quantity, method of delivery and the type of packaging, the buyer can be sure that the seller has fulfilled all the conditions specified in the contract for sale, but otherwise the payment by letter of credit will not be made.
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