Documentary Credit: Definition, Main Actors and How It Works

A documentary credit is an undertaking by a bank, the issuing bank, to pay a named beneficiary, usually the exporter, when the beneficiary presents documents that comply with the credit terms. The credit states the amount, the expiry date, the documents required, and the latest shipment date, and it is issued at the request of the applicant, usually the importer. Once issued, the credit is a bank commitment, which means the exporter no longer depends on the importer willingness to pay, but on the bank promise to pay against complying documents. The credit is governed by the ICC Uniform Customs and Practice for Documentary Credits, known as UCP 600, which sets the rules banks follow worldwide. The main actors are the applicant, the beneficiary, the issuing bank, and the advising bank. The applicant is the importer who asks its bank to issue the credit. The beneficiary is the exporter who will be paid under the credit. The issuing bank is the applicant bank, which gives the payment promise. The advising bank is usually a bank in the exporter country, which tells the beneficiary that the credit has been issued and checks that it looks genuine. Other actors can join, including a confirming bank that adds its own promise, a nominated bank that is authorised to pay, and a presenting bank that handles the documents. Each actor has a defined role under UCP 600, and no actor can be forced into a role it did not accept. The credit works in a clear sequence that starts with the sales contract. The importer and exporter agree the goods, the price and the payment by documentary credit, and the importer asks its bank to issue the credit. The issuing bank sends the credit to the advising bank, usually by SWIFT MT700, and the advising bank tells the exporter that the credit is available. The exporter ships the goods, collects the transport document, the invoice, the packing list and any certificates, and presents them to its bank. The bank checks the documents against the credit terms, and if they comply, the exporter is paid. The documents then travel to the issuing bank, which checks them again and releases them to the importer, who uses them to collect the goods. The most important rule is that banks deal in documents, not in goods or performance, so the bank checks the bill of lading, the invoice amount and the required documents, not whether the machinery works. If the documents comply, the bank must pay even if the importer later claims the goods are faulty, and if they do not comply, the bank must refuse even if the goods are perfect. When documents are late, missing, or wrong, the bank raises a discrepancy and asks the applicant whether it will waive the problem, and if the waiver is refused the documents are returned and the exporter is not paid. The system must record each discrepancy, each waiver request and each decision with a time stamp, because this is the most common exception in trade finance. For example, an importer asks its bank to issue a documentary credit for EUR 50,000 in favour of an exporter, with an expiry date 90 days later and a latest shipment date 60 days after issue. The exporter ships the goods, presents the bill of lading, the invoice for EUR 50,000 and the packing list, and the bank checks each document against the credit terms. If every document complies, the exporter is paid EUR 50,000, and the documents travel to the importer, who uses them to collect the goods.