A documentary letter of credit is a promissory note from the issuer (i.e. issuing bank) to the supplier (i.e. beneficiary) that the issuer will pay the beneficiary money when the beneficiary provides certain documents to the issuer in a stipulated manner, time and place. In the event that the buyer (applicant) is not able to make the payment on the purchase, the beneficiary may make a demand for payment on the bank. The bank will examine the beneficiary’s demand and if it complies with the terms of the letter of credit, will honor the demand.

A documentary letter of credit is issued by a bank or a financial institution. The letter of credit assures the supplier (beneficiary) that they will receive payment up to the amount stated in the letter of credit, provided that the beneficiary makes a compliant document presentation clearly stating what documents the beneficiary must present, what information they must contain, and the place and date it expires. Even if the buyer (applicant) cannot pay for the beneficiary’s services, once a compliant presentation is made by the beneficiary,  the Issuer has the obligation to honor the presentation.

Documentary letters of credit are mostly used in international transactions, where the buyer and seller operate in different countries and have yet to establish a strong relationship. Due to physical distance between the two parties and foreign or unknown legal systems, when concluding a deal with a buyer the seller is exposed to risks 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. A letter is credit is a document that mitigates such a risk and provides seamless business solution and greater financial comfort.

The parties to a letter of credit are.

•    The supplier (beneficiary),
•    The issuer ( issuing bank),
•    The buyer (applicant), who is also the bank’s client,
•    An advising bank, of whom the beneficiary is a client.

The beneficiary needs to present certain documents before its expiration which are directly related to the deal between the supplier and the buyer.  These documents must confirm that the supplier has fulfilled his part of the transaction. Once the supplier makes a compliant presentation, the issuer pays regardless of the buyer’s actions. An issuer on its own discretion might make a payment even if he finds a technical discrepancy in the documents, so long as he is confident that the deal is going as planned.

When a buyer takes advantage of a documentary letter of credit, he frees up capital that would otherwise be tied up with the supplier in the form of a security deposit. Due to this ability to boost an applicant’s cash flow, documentary letters of credits are a very important aspect of international trade for deals of all sizes.