Operation of documentary credit is explained in two stages:
- Opening of Letter of credit &
- Negotiating of documents under Letter of credit.
1) Opening of Letter of credit:
Why there is a need to open a Letter of credit? In International trade, Importer and Exporter stay in different countries. The risk involved is high. To make sure that both the parties are genuine and are not involved in any fraud they prefer to introduce bank for the trade. In any trade, both buyer & seller enter into a contract termed as Sales Contract for the supply of goods or service in exchange for money. Once the buyer and seller agree to common terms of transactions, seller request buyer to open a letter of credit in his favor so that he can be sure of payment after he has dispatched the goods and submitted the required documents as per terms of LC.
Under documentary credit arrangement (also called letter of credit arrangement) a bank (usually in the importer’s country) undertakes to pay for a shipment, provided the exporter submits the required documents (such as a clean bill of lading, certificate of insurance, certificate of origin) within a specified period.
In other words, we can say documentary credit is an international trade procedure in which the credit worthiness of an importer is substituted by the guaranty of a bank for a specific transaction.
2) Negotiation of documents under a letter of credit:
After shipment, exporter submits the documents for payment to his bank. The exporter bank upon receipt of documents will examine the same thoroughly and if the same are found to be in order as per terms of credit will pay to the exporter and will claim the amount as per reimbursing instructions.
We have tried to explain the negotiation of documents under a letter of credit from the above flow chart
- Exporter exports the shipment as per the sales contract and obtains the documents (BL, Certificate of Origin, Certificate of Insurance etc).
- Exporter submits the documents to his bank for payment.
- Exporter bank checks the documents with the reference to the LC and once found in order, makes the payment to the exporter.
- Exporter sends the documents to the buyer’s bank and request for the payment.
- Buyer’s bank informs the buyer and request for the confirmation.
- The buyer gives the confirmation and requests to make the payment to the Exporter’s bank.
- Buyer’s bank makes the payment to the Exporter’s bank NOSTRO Account.