The basic and most common forms of settlement of international trade transactions are open account (where payment on delivery is the most common), documentary collections, documentary letters of credit and payment in advance.
There are numerous features, variations and options related to these payment types which make them very flexible, adaptable and enduring as business solutions.
It should be noted explicitly that certain payment options or types of payment transactions have a variety of features or characteristics, which can be incorporated in a given transaction, or not. A documentary credit, may be payable at sight (immediately) or on a term basis (at maturity, at an agreed date in future).
The use of certain features changes the nature of the transaction. However, the payment is still effected through a documentary credit in the end.
The FITTskills International Trade Finance training course considers each instrument type/variation in turn, in the following order:
Open account and payment in advance
These are the two extreme options, providing maximum security to one party and exposing the other party to the greatest risk.
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Payments on an open-account basis are basically transfers of funds to the account of the exporter. Historically, open-account payments have been used in trade between very stable and secure markets such as the United States and Canada, or in intra-EU trade, and in cases where the trading relationship is established and trusted.
At the opposite extreme, payment in advance presents the highest risk to the importer, given that the exporter could easily receive the funds and not carry through with the promised shipment.
These are somewhat secure, but generally used in established trading relationships involving reasonably stable and secure markets.
Documentary collections are types of transactions where banks act as intermediaries between the importer (buyer) and exporter (seller), in effect, agreeing to facilitate payment to the exporter only once a set of shipping documents has been prepared and presented to an intermediary bank.
These documents typically include documents of title to the cargo, representing ownership of the goods as well as demonstrating that the goods have been shipped.
These offer the most balanced security for both parties. Documentary letters of credit (abbreviated as DLC, D/C or L/C) are trade finance instruments issued by a bank on behalf of an importer, promising payment to an exporter, provided that all the terms and conditions specified in the letter of credit are fully complied with by the exporter.
CAUTION: 60-70% of documents presented by exporters under Documentary Credits are in some way non-compliant with the terms of the Letter of Credit (L/C).
In those instances, the protection to the exporter is minimal, as the importer can refuse the shipment, or take advantage of the discrepancies to demand a substantial discount on the shipment. Some banks exercise judgment and will not identify “trivial” discrepancies, while others take a very literal approach to the examination of documents.
Confirmed documentary credits
These provide additional security to the exporter, while preserving security for the importer. The basic documentary letter of credit is a straightforward instrument which represents a payment promise by the issuing bank in favour of the exporter or beneficiary against the presentation of fully compliant documents.
Documentary letters of credit offer numerous powerful and valuable features that address certain aspects of trade finance. A major one of these features is referred to as a confirmation of a documentary letter of credit. A confirmed documentary credit (contrast the basic, unconfirmed letter of credit described above), is one in which an additional, separate and independent payment undertaking is added to that of the issuing bank by another financial institution—the confirming bank—to provide further security to the exporter.
Confirmation is added at the request of the issuing bank, on behalf of the exporter.
If an exporter is considering exporting to a high-risk market, and is not reassured by a straightforward documentary credit, the option to confirm that letter of credit may provide the added comfort that will enable the exporter to proceed with the transaction.
Major features and characteristics of various payment options are discussed in greater detail throughout the FITTskills International Trade Finance course.