Documentary credit 

How can it help me?

Payment by documentary credit enables you to move the payment risk of your export contract from your overseas buyer to your buyer’s bank.

What is it?

A documentary credit—also called a letter of credit—is a conditional guarantee of payment in which an overseas bank takes responsibility for paying you after you ship your goods, provided you present all the required documents (such as documents of title, insurance policies, commercial invoices and regulatory documents).

A documentary credit is a separate contract from an export contract. The parties to a documentary credit deal with documents, not the goods that the documents relate to.

Documentary credits are a common method of payment in the international trade of goods as they offer some protection to both you and your buyer.

How does it work?

The main steps in a typical documentary credit transaction are:

1. When you’ve finalised the export contract, your buyer (the applicant) arranges with a bank to open a documentary credit in your favour. This foreign bank is called the issuing bank (or opening bank) and will usually check your buyer’s creditworthiness.
2. The issuing bank sends the documentary credit to an Australian bank (theadvising bank). The advising bank verifies the authenticity of the documentary credit and forwards it to you (the beneficiary).
3. The documentary credit sets out the documents you must present to receive payment. When you’ve shipped the goods and compiled all the necessary documents, you lodge the documents with your Australian bank—called thenegotiating bank—to arrange the payment. In most cases, the advising bank and the negotiating bank are the same bank and may be your regular business bank.
4. The negotiating bank checks the documents to ensure the terms of the documentary credit have been met. It then sends the documents to the issuing bank with a request for payment. Sometimes a third bank, called areimbursing bank, acts as an intermediary between the negotiating and issuing banks.
5. If the issuing bank is satisfied that you’ve provided all the necessary documents in the exact form required by the documentary credit, it forwards the payment to the negotiating bank, which in turn pays you. A documentary credit will state whether you receive payment ‘at sight’ (immediately after bank verification of the documents) or at an extended term (for example, 30 days after sight).Types of documentary credit include:
   • irrevocable—cannot be cancelled or amended without the consent of all parties, including the beneficiary. This is the most common type of documentary credit in the international trade of goods
   • revocable—can be cancelled by the issuing bank without warning to the beneficiary
   • confirmed—a ‘confirming’ bank (either in Australia or overseas) agrees to pay you under a documentary credit, whether or not payment is received from the issuing bank
   • transferable—the original beneficiary of the documentary credit can transfer their rights to a second beneficiary on the same or similar terms as the original documentary credit (the original beneficiary may be an intermediary between you and your ultimate buyer)
   • revolving—allows automatic reinstatement of the documentary credit after the amount for the original shipment has been paid, so subsequent shipments to your buyer are covered by a single documentary credit
   • standby—a contingency documentary credit which you can draw on if your buyer, using another payment method, defaults in making a payment to you under the export contract
   • back-to-back/complementary—where your buyer is the beneficiary of a separate documentary credit (in their capacity as a seller under a separate sales contract), they can sometimes use this credit as security to apply to their bank for a complementary documentary credit to cover their payment under an export contract with you
   • red clause—pre-shipment finance that allows you (the beneficiary) to receive an advance from the advising bank of all or part of the amount owed to you under a documentary credit so you can buy raw materials or other inputs required to manufacture the product for export.

   • The diagram below shows the main steps in a transaction involving payment by irrevocable documentary credit.

     

      

     Notes to diagram

     1. You enter into an export contract with your overseas buyer.
     2. The buyer asks its bank (the issuing bank) to issue an irrevocable documentary credit (IDC) in your favour.
     3. The issuing bank issues the IDC to your bank (which in this example acts as both the advising and the negotiating bank).
     4. Your bank forwards the IDC to you.
     5. You send the goods to the buyer in accordance with your export contract.
     6. You provide to your bank the documents required by the IDC.
     7. Your bank sends the documents to the issuing bank.
     8. The issuing bank checks that the documents comply with the IDC and if so, pays your bank.
     9. Your bank pays you.

     How risky is it?

     A range of payment methods is used in international trade, with payment taking place at a different stage of the export transaction in each. In general, this means that each method has a different level of non-payment risk for you, the exporter, and non-delivery risk for your buyer.

     The diagram below illustrates the risk of payment by documentary credit compared with other payment methods.

     

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What are the pros and cons?

What costs are involved?

• Your buyer pays the issuing bank to open and process a documentary credit.
• The Australian bank will charge you a fee for advising and negotiating the documentary credit. You may pay a further fee if the credit is confirmed by another bank or if you receive an advance.

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