Definition, nature and purpose of a Documentary Credit

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Article 2 of the Uniform Custom and Practice for Documentary Credit defines a documentary credit as: "For the purpose of these articles, the expression documentary credits and standby letters of credit (hereinafter referred to as credits) means any arrangements, however named or described, whereby a bank (the issuing bank) acting on request and on the instructions of a customer (the applicant) or on its own behalf:
  1. is to make a payment to or to the order of a third party (the beneficiary) or is to accept and pay bills of exchange (drafts) drawn by the beneficiary, or,
  2. authorizes another the bank to effect such payment or to accept and pay such bills of exchange (drafts) or,
  3. authorizes another bank to negotiate, against stipulated documents, provided that the terms and conditions of the credit are adhered with".
In a layman language, a documentary credit may be describe as a legal undertaking in writing. It is issued by the customer's bank (also known as the issuing bank) at the specific instruction of its customer, the buyer/importer (known as the applicant).

By this document, the issuing bank (buyer's bank) undertakes to pay a certain sum of money to a named beneficiary (seller/exporter) provided the later tenders the stipulated documents and strictly adhere to the terms and conditions specified in the documentary credit.

The payment may be made by the bank to the beneficiary when the documents has been presented and upon due compliance of the terms and conditions in the documentary credit (sighting), or payment may be made at a future specified date (deferred payment documentary credit) or on the maturity date of a bill of lading drawn by the beneficiary and duly accepted (term documentary credit).

The documentary credit provides a more equitable and acceptable method of payment to both buyer and the seller. To the seller, he can expect that the payment will be made by the bank upon presentation of the said documents and due compliance of its terms and conditions mentioned in the documentary credit.

To the buyer, he can expect that his interests will be protected in that payment will be only be made upon presentation of the stipulated documents and compliance of its terms and conditions specified in the documentary credit.

A documentary credit is also known by various names, for example, the letter of credit (LC), documentary letter of credit, commercial letter of credit, banker's letter of credit or payment credit.

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