The Treasurer’s Guide to Trade Finance

A Reference Guide to Trade Finance Techniques

Understanding the documentary credit
process

The process of documentary credit

1. Parties agree contract of sale.
   As far as possible, the details of the
   contract of sale should be negotiated to
   cover all possible circumstances. This
   should minimise the risk of problems at a
   later date. One way to do this is to use a
   set of terms and conditions prepared by
   the seller as the basis for negotiations.
   The finalised version can then be used by
   the buyer when asking its bank to open
   the letter of credit.
   The contract terms and conditions
   should include a description of the
   goods, the price (including currency)
   and the payment terms. Depending
   on the currency chosen, one or other
   party may want to consider hedging
   the associated foreign exchange risk.
   Both parties will also need to address
   how to meet any export/import controls,
   including procurement of any licences and
   compliance with any exchange controls.
   The details of the delivery of the goods
   should also be agreed. Factors to agree
   include the timing of the delivery of the
   goods, the means of transport to be used,
   the point of delivery, insurance, and the

use of an Incoterm. Agreement should

also be reached on what should happen

in the event of delays in shipping, or at the

customs points.

Both parties should also consider

clauses to protect their specific interests.

For the seller, these will concentrate on

the creditworthiness of the bank issuing

the letter of credit on behalf of the buyer.

This will include getting precise information

about the issuing bank (in some locations

there will be a number of different entities

operating as part of the same group). If

concerned about either the credit risk of

that bank or the country risk of the bank’s

location, the seller should consider whether

it is appropriate to ask its bank to confirm

an issued letter of credit. There will be a

cost associated with the confirmation, so

this should be factored into the cost of sale.

The buyer will need to agree a

credit facility for the issuing of letters of

credit. This facility will need to be large

enough to allow the buyer the flexibility

to make purchases as necessary, whilst

recognising that any unused portion of

the facility will use up the company’s

scarce credit capacity. Working capital

ratios will help the treasurer to identify the

appropriate size of the credit facility.

Finally, the two parties must confirm

which documents should be required to be

exchanged under the terms of the letter

of credit itself. The final agreement should

comply with the UCP 600. The seller, in

particular, will need to be confident it will

be able to produce all the documents

as agreed under the terms of the letter

of credit, both accurately and within the

agreed timescale.

2. Buyer asks its bank to open a letter of
   credit.
   This should be in accordance with the
   terms agreed in the contract, using the
   template terms and conditions negotiated
   between the two parties, if appropriate.


3. Buyer’s bank issues letter of credit to
   seller’s bank (note this is not necessarily
   the account-holding bank).
   As long as the buyer has a sufficient credit
   line in place, the buyer’s bank (the issuing

Physical movement of goods

Movement of commercial documents

Payment or movement of financial

documents

1

8 11 10 10

6 10

11

9

2

3

4

Buyer’s

Bank

Buyer

Carrier

Seller

5 7

Seller’s

Bank