Documentary credit system of transaction
This is a sort of money transfer system to enable sellers to obtain early payment soon after the delivery of the goods.
A documentary credit—also called a letter of credit—is a conditional guarantee of payment in which an overseas bank takes responsibility for paying the seller after he has shipped the goods and provided he presents all the required documents (as listed in the L/C, such as documents of title, insurance policies, commercial invoices and regulatory documents etc) by the date agreed in the Letter of Credit.
This system relies heavily on documents, which are checked by the banks involved. 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.
An example:
A – Seller in India
B – Buyer in USA
– ‘A’ and ‘B’ conclude their contract which specifies payment by documentary credit
– ‘B’ instructs his bank in the U. S. A to open a “credit facility in favour of ‘A’
– ‘B’s bank in the U. S. A verifies B’s credit worthiness and issues a letter of credit (LOC) containing terms of the credit e.g. Time of loading, documents required, etc.
– ‘B’s bank sends the LOC and delivers it to ‘A’
– ‘A’s bank in India checks the LOC and delivers it to ‘A’
– ‘A’ dispatches the goods, sets all documents in order as required by the LOC. Normally these are invoice, insurance certificate, full set of clean bills of lading which are obtained once the goods are shipped
– ‘A’ presents all documents to his bank in India by the date stated in the LOC and asks for payment
– ‘A’s bank checks the documents against the LOC and if they comply, especially regarding clean B/L, pays ‘A’ fully and dispatches the documents to ‘B’s bank in the U. S. A
– ‘B’s bank in the U. S. A. again checks the documents against the LOC. If they comply then it releases all documents to ‘B’ against payment and then reimburses ‘A’s bank in India
– ‘B’ receives the document, which enables him to obtain the release of the cargo when the ship arrives in port