Definition
A documentary credit is a means of payment available to companies that are active internationally. It provides security for their import/export transactions. A documentary credit is also known as "credoc" or "letter of credit".
The use of a documentary credit has the following advantages:
- payment to seller is guaranteed, upon presentation of the documents proving that the goods were shipped
- the buyer is guaranteed that payment will only be made when the goods have been shipped in compliance with contractual conditions.
Persons involved
Documentary credit involves the following:
- the buyer, who initiates the request for documentary credit from its bank
- the seller, who provides the goods to the transporter and provides the required documents to its bank or that of the buyer
- the buyer's bank (issuing bank), that serves as a guarantor with respect to the seller
- in some cases, the seller’s bank, that may serve as intermediary between the issuing bank and the seller
Characteristics
The level of commitment of the parties involved varies depending on the chosen documentary credit, that may be:
- revocable: it may be revoked or modified at any time without notice by the issuing bank or the buyer
- irrevocable and notified: the buyer's bank is involved in a firm and irrevocable manner. It may thus not be modified or canceled without the agreement of all parties. The seller's bank assumes no risk
- irrevocable and confirmed: it presents the same characteristics as an irrevocable and notified documentary credit, but the seller's bank is committed to pay upon receipt of the compliant documents.
Setup
The buyer and the seller sign a commercial contract that specifies the method of payment by documentary credit (1).
The buyer requests to open a documentary credit with its bank (2). It should be noted that the bank may request guarantees from the buyer that can cover the risk (blockage of the amount of the documentary credit on a special account, guarantee deposit, or other guarantee).
The buyer's bank issues the documentary credit and notifies the seller or their bank (3) that verifies its authenticity before notifying their client of it (4).
The diagram below illustrates the different phases of putting a documentary credit in place ("crédoc"):
Usage
The seller remits the goods to the carrier (5) and provides the required documents to the buyer's bank or to their own bank (6) that verifies them before providing them to the buyer's bank (7). The required documents are in principle the invoice, the insurance, and the transport title.
The buyer's bank verifies the compliance of the documents remitted and makes payment to the seller (8).
The buyer repays its bank in exchange for the documents (9). The buyer presents the documents to the carrier in order to receive the merchandise (10).
The following diagram illustrates the different phases of the use of a documentary credit:
