Have You Ever Asked…What Is A Letter Of Credit?
In order to facilitate trade, letters of credit achieve their purpose by using the credit of the customer rather than the credit the bank.
There are mainly two types of letters of credit: commercial and standby.
The commercial letter of credit is often known as a Documentary Letter of Credit (DLC) and is a primary payment instrument for a transaction, whereas the Standby Letter of Credit (SBLC) is a secondary payment instrument.
Documentary Letter of Credit (DLC)
Used for centuries, documentary letters of credit have simplified payment in international trade. They will continue to be used more and more as the global economy keeps growing.
A Documentary Letter of Credit (DLC) is a contractual agreement between two banks. The first bank is known as the issuing bank, authorizes another bank, known as the advising or confirming bank, to make payment to the beneficiary.
The issuing bank, on the request of its client (applicant), opens the documentary letter of credit for a specific amount of money and makes a commitment to honor drawings made under the credit to the beneficiary.
The issuing bank makes payment on presentation of specified documents representing the supply of goods within a specified time limit and place.
The documents presented must meet the terms and conditions that are set out in the Documentary Letter of Credit.
The beneficiary is usually the provider of goods and/or services. In short, the issuing bank replaces the bank's client if the client fails to pay the beneficiary.
Players in a Documentary Letter of Credit (DLC)
The Issuing Bank
The issuing bank becomes liable to pay and to be reimbursed from its client according to the terms and conditions of the Documentary Letter of Credit.
The role of the issuing banks is to provide a guarantee to the supplier/seller that in the case that compliant documents are presented, the issuing bank will examine the documents and pay the seller the amount due.
Of course, the issuing bank will only pay if the compliant documents comply with the terms and conditions set out in the Documentary Letter of Credit (DLC).
In most cases, the documents requested will include a commercial invoice or pro forma invoice, a transport document such as an airway bill or bill of as well as an insurance document, however, there can be many others.
Documentary Letters of Credit are a business deal of documents, not goods and services.
The Advising Bank
The advising bank is usually a foreign bank that advises the beneficiary. In most cases, the beneficiary uses a local bank to make sure that the Documentary Letter of Credit is valid.
In addition, the advising bank is responsible for sending all the required documents to the issuing bank. The advising bank has no other obligation under the Documentary Letter of Credit.
The advising bank is not required to pay in the case that the issuing bank does not pay the beneficiary.
The Confirming Bank
The confirming bank may confirm the Documentary Letter of Credit for the beneficiary if the issuing bank requests it.
The confirming bank obligates itself to make sure payment is made under the Documentary Letter of Credit (DLC).
The confirming bank won’t confirm the letter of credit until it has checked the country and the bank where the letter of credit originated.
More times than not, the confirming bank is also the advising bank.
The beneficiary is to receive payment as long as he can provide the documentary evidence required by the Documentary Letter of Credit (DLC).
The documentary letter of credit is an entirely separate transaction than the contract on which it is opened.
All the parties involved deal in documents and not in goods or services. The issuing bank is never liable for the performance of the underlying contract between the client and the beneficiary.
The issuing bank's only obligation to the buyer is to ensure that all of the terms and conditions of the credit are met by sufficiently examining all of the documents.
When demanding for payment, the beneficiary is simply stating that all conditions of the agreement have been completed.
If the beneficiary (seller) conforms to the seller must be paid by the issuing bank.