What is Documentary Credit?

Malcolm Tatum

Also known as a commercial letter of credit, documentary credit is a type of international trade procedure that makes it possible to make use of a covenant from the bank of an importer to honor a purchase agreement made with an exporter as the basis for the deal, rather than considering the credit rating and worthiness of the importer. Sometimes referred to as a letter of credit arrangement, the exporter and his or her bank accept the commercial letter of credit issued by the importer’s bank as being sufficient to accept and process the order. The documentary credit is often included in other key documents related to the purchase, including the bill of lading, the certificate of origin, and any insurance documents related to the items purchased and the shipping process.

Man climbing a rope
Man climbing a rope

The chief benefit of documentary credit is that it minimizes the need to confirm the credit worthiness of the buyer in an international trade. Since the letter of credit arrangement is issued by a bank on behalf of the buyer, the seller can safely assume that the order will be paid for according to the terms of the purchase agreement, and that those payments will be rendered on time. Essentially, the bank that issues the commercial letter of credit is making a promise to honor the debt, an arrangement that greatly minimizes any risks that the exporter takes on when entering into a sales transaction with an importer.

There are actually two different types of documentary credit. One is known as an import or export letter of credit, and serves the purpose of aiding in the successful completion of a trade that has already been initiated. A second type, known as a standby letter of credit, is more open-ended and may be used as a financial tool in initiating a trade with more than one particular exporter. In both situations, the idea is to make sure the seller is guaranteed payment in a timely manner, without the need to run credit and other types of checks on the buyer before agreeing to process the transaction. When the documentary credit is presented early on, the sale can progress quickly, often with fewer delays. This can be especially important if the goal of the importer or buyer is to quickly resell the purchased goods at a profit, and must do so in a fixed time frame in order to avoid losing a potential sale.

Documentary credit is a process that protects the interests of all parties concerned. Sellers have the assurance that a verifiable and reputable financial institution is backing the purchase and that funds will be transferred according to the terms of the sale. At the same time, buyers can utilize this approach to avoid delays associated with credit checks and work through the bank to make sure the transaction goes smoothly, goods are delivered on time, and any opportunities to profit from the resell of the goods are not lost. For this reason, many buyers who rely on imported goods to earn a living will use this approach to save time and increase the chances of earning returns quickly from their purchases.

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