Documentary letters of credit are mostly used in international transactions, where the buyer and seller have yet to establish a strong relationship and/or operate in different countries. When concluding a deal with a buyer from a different country, the seller is exposed to risks due to the physical distance between the two parties, foreign or unknown legal systems, and lack of knowledge about the buyer. A seller may be hesitant to enter such a risk-sensitive deal without a letter of credit as financial security.
Sellers/Exporters and Buyer/Importers usually require an intermediary such as a bank or financial institution to guarantee payment as well as the delivery of goods.
This is where the Documentary Letter of Credit (DLC) comes in. Once the terms specified in the Documentary Letter of Credit (DLC) are fulfilled and the buyer/importer cannot pay, then seller/exporter can make a compliant document presentation to demand payment.
When the seller/exporter makes a compliant presentation, the issuing bank or financial institution will make a payment to the seller/exporter.
Documentary Letters of Credits (DLC) are mostly used in international business transactions, where the buyer/exporter and seller/importer have yet to build a close business relationship and/or are located in different countries.
When closing a business deal with a buyer/importer in a foreign country, the seller/exporter is exposed to certain risks including international legal systems and a lack of trust with the buyer/importer.
Dues to this, a seller/exporter can be hesitant do such a deal without a Documentary Letter of Credit (DLC) from a trusted credit-worthy bank or financial institution as financial security.
The process of getting an LC consists of four primary steps, which are enlisted here:
After the parties to the trade agree on the contract and the use of LC, the importer applies to the issuing bank to issue an LC in favor of the exporter. The LC is sent by the issuing bank to the advising bank. The latter is generally based in the exporter’s country and may even be the exporter’s bank. The advising bank (confirming bank) verifies the authenticity of the LC and forwards it to the exporter.
After receipt of the LC, the exporter is expected to verify the same to their satisfaction and initiate the goods shipping process.
After the goods are shipped, the exporter (either on their own or through the freight forwarders) presents the documents to the advising/confirming bank.
The bank, in turn, sends them to the issuing bank and the amount is paid, accepted, or negotiated, as the case may be. The issuing bank verifies the documents and obtains payment from the importer. It sends the documents to the importer, who uses them to get possession of the shipped goods.