What is a Direct Letter of Credit and how does it differ from a Documentary Letter of Credit and a Standby Letter of Credit?
A Direct Letter of Credit or Direct-Pay Letter of Credit is fundamentally different from a Documentary Letter of Credit. However, in some quarters it is regarded as a special form of Standby Letter of Credit. Unlike Bank Guarantees there are no direct or indirect Letters of Credit. All three instruments are a means of payment.
Direct-Pay Letter of Credit
A Direct-Pay Letter of Credit is similar to a Standby Letter of Credit. They are both financial instruments issued by a bank. The bank that issues the Direct-Pay Letter of Credit will pay directly to the beneficiary. A Direct-Pay Letter of Credit has no clauses regarding performance or non-performance of the seller.
The issuing bank will pay the beneficiary immediately on presentation of the draft. They will pay providing the requirements of the draft document have been met. The issuing bank will claim the same from the buyer.
A draft or sight draft is a payment document where the buyer agrees to pay the seller immediately on receipt of goods. In the case of a Direct-Pay Letter of Credit it is the bank that pays immediately without reference to the buyer.
Essentially this is a riskier version of a Standby Letter of Credit. It is still used as to cover any default on behalf of the buyer. But as the seller can claim before any goods are shipped it is very rarely used between a buyer and a seller.
Documentary Letter of Credit
A Documentary Letter of Credit is a negotiable financial instrument issued by a bank. A Documentary Letter of Credit is a promise to pay by the issuing bank on behalf of the buyer. Payment will only be made if the seller complies exactly with the terms and conditions contained within the Documentary Letter of Credit.
The terms and conditions usually refer to a set of documents. These documents can be identified as,
- Packing List
- Bill of Exchange or Draft
- Bill of Lading
- Certificate of Origin
- Airway Bill (if air freight)
- Road Transportation Document (if road freight)
- Insurance Policy and Certificate
- Commercial or Pro Forma Invoice
- Inspection Certificate
Many of these documents will require copies, in some cases up to 6 copies. The seller will combine these documents with their copy of the Documentary Letter of Credit. They will approach their bankers with all the documents and request payment under the Documentary Letter of Credit.
If all the required documentation matches the terms and conditions of Documentary Letter of Credit, the bank will pay the seller. Under the terms and conditions of the Documentary Letter of Credit the sellers bank will seek reimbursement from the buyer’s bank.
The buyers bank will reimburse the sellers bank and claim the same from the buyer. In reality the buyers bank will already have taken the cash equivalent from the buyer. If the buyer is of good standing the bank may well have issued the Documentary Letter of Credit on margin. On margin means the buyer is good for the money.
These bank instruments are utilised daily on a global basis. Here in Switzerland Documentary Letters of Credit are being issued and negotiated daily. The same happens throughout the whole world. The Documentary Letter of Credit underpins international trade.