Letters of Credit: The Basics

Definition

A documentary credit is a (conditional) bank undertaking of payment. It is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and on the instructions of the buyer (applicant) to pay at sight or at a determinable future date up to a stated sum of money, within a prescribed time limit and against stipulated documents or other conditions. The issuing bank is putting out its credit and good name for the sake of the buyer.

Seller

Because the documentary credit is a bank undertaking, the seller can look to the bank for payment, instead of relying upon the ability or willingness of the buyer to pay. However, because the undertaking is conditional, the seller only has the right to demand payment if he meets all the requirements of the credit. It is, therefore, unwise for the seller to proceed with shipment until he is aware of these requirements and is satisfied he can meet them.

Buyer

Because the documentary credit is a conditional undertaking, payment is made on behalf of the buyer against documents, which may represent the goods and give the buyer rights to them.

Summary

Documentary credits therefore:

· Are an arrangement by banks for settling international commercial transactions.

· Ensure payment, provided that the terms and conditions of the letter of credit have been fulfilled.

· Mean that payment by such means is based on documents only, and not on merchandise or services involved.

· Provide a form of security for the parties involved.