- July 18, 2023
- Posted by: Nikhil Sharma
- Category: Blog
In global trade, documentary LC perform a vital part in providing a high guarantee of the transaction between seller and buyer in different countries. It performs as a financial tool that gives a guarantee and reduces the hazards for buyers and sellers. So, if you are running a transport business or a professional in an international trading business, then you definitely need to consider the crucial components of a letter of credit.
Every business consists of a transaction between a minimum of two parties. These parties can be a buyer, a seller, banks, governments, agencies, etc. While carrying out a transaction, there is a small amount of risk that the parties are exposed to. This is due to the fact that there are changing dynamics of international transactions such as at the time of sale, and payment time.
It is normal that the seller would want to get the payment either before the delivery or at the time of making the delivery. This is because the seller cannot afford to bear the loss of transportation providing that he is investing at the time of manufacturing. On the other hand, the buyer cannot make the prior payment as he is well aware of the fact that it would take up to a month or two to ship his order. This is why both of them prefer that the other party fund the transaction and pay for the cost.
Providing cash by the buyer will make the seller feel secure whereas it will leave the buyer in anticipation. Therefore, the documentary LC comes into play. To get more insight into this, we must familiarise ourselves with this term.
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What is a documentary letter of credit?
It is a token of promise by the bank to pay on the buyer’s behalf provided that the seller abides by the well-defined terms and conditions mentioned in the credit. The parties that are included in the transaction are:
Assurance of payment
Here, the applicant is the buyer the beneficiary the seller and the last one is the bank. The documentary LC provides equal security to both buyers and sellers. When a buyer and seller use a letter of credit, the bank takes on the responsibility of making the payment to the seller on behalf of the buyer. This means that the bank’s reputation and financial standing are trusted by both the buyer and seller. With the letter of credit, the buyer and seller don’t need to talk directly to each other. Instead, the bank acts as a middleman, ensuring the payment is made safely.
LCs are the most frequently used mode of payment in international trade. As it is said to provide very high protection for both parties involved. The buyer notifies the seller about the documents that they need before the bank makes the payment. This provides the seller with a sense of relief that he will receive his payment after shipping the goods as long as he is providing the said documents as requested by the buyer. This way, both parties are at ease that their obligations are being met in the transaction.
Documentary collections are the security bills of exchange that are used as trade transactions where the seller is dependent upon banks to handle the payment with the buyer. These documents are cost-effective and easier to use as compared to the documentary LC. it is the same as multinational COD (cash on delivery). The seller instructs the bank to collect the documents like the invoice, bill of lading, and others from the buyer’s bank also known as the collecting bank. Then these documents are forwarded to the buyer when the payment is made or the draft is accepted.
As an LC promises a guaranteed payment to the seller, the documentary collections do not promise payment to the seller. Instead, they provide a flexible and cost-effective way to settle trade transactions. Unlike other methods, where the seller has control over the goods till the buyer pays the amount or accepts the draft. These methods are used when the buyer and seller have an existing relationship, which means they have already been dealing with each other and hence, have faith in one another’s commitment to meet their responsibilities. However, it is crucial for both entities to rigorously review the collection terms and conditions to make sure that there is a secure and seamless transaction process.
Other types of documentary collections include open accounts which are known as the least secure method f payment. It is used in the scenario of low-risk markets. The buyer accords to pay in a specified period of time after the goods are received. Usually, the specified period is 30, 60, and 90 days. This makes the seller completely rely upon the buyer that they would pay the entire amount in the agreed time.
The payments are usually transferred in the form of:
The open accounts provide the buyer with a sense of security and flexibility. Whereas, the seller is exposed to a great risk of the buyer not complying with the conditions of the contract and payment. The usage of open accounts is limited in cross-border trade as compared to domestic trade.
Advantages of documentary LC
Fostering new trade relationships
They allow the trading partners to engage with parties that are unfamiliar to them thereby, creating new relationships
With the utilization of LCs, businesses can easily venture beyond geographical boundaries. They can even expand vividly.
Effectiveness and stability
The LCs offer a highly reliable and stable method of trade settlement. And gives a sense of assurance to both the parties involved.
Tailored terms and conditions
The trading partners can negotiate and inculcate those terms and conditions that serve their personal requirements. This will prepare a compilation of mutually agreed-upon clauses.
The bank’s involvement in the letter of credit ensures there are no conflicts among the trading parties.
The letter of credit enhances the exporter’s financial soundness since it involves the transfer of responsibility of payment from the exporter or buyer o the issuing bank.
The use of LCs provides larger institutions the authority to conduct numerous transactions simultaneously.