Documentary Credit Transaction - Essay Example

Introduction The trade partners have strived for the sustainable success, and have been successful in development of corporate and business relationship with its valued customer. The banking institute has tried to evolve a healthy relationship with their partner, based upon mutual trust and understanding, the banking institute understand the responsibility on their part, and has tried to accomplish objectives and aims through recognition of its role and responsibility "as a financial intermediary brings with it a duty of responsible conduct and engagement". The banking institute has introduced certain amendments and reforms in its policies, and has tried to broaden the scope of its services. Before the beginning of the century, the banking institute focused heavily on wealthy class that was because during that era the economic wealth was extremely concentrated, therefore the wealthy class was supported and encouraged to involve in different financial schemes, aimed at creation of wealthy opportunities. The economic activities have accelerated in the current century, the economic opportunities have been explored, and wealth proportion has expanded instead of getting more concentrated. The trade partners therefore adopted a policy of variance, aimed at adaptability towards economic progression. The economic expansion and rapid circulation of wealth intensified the activities of the banking sector, and for the procurement of its share, the trade partners broadened the horizon of its banking facilities. The requirements and the expectations of the consumers revolutionized, and for this purpose the banking sector was compelled to adopt and introduce set of revised and modified scheme which primarily focused on lending services, the deposition activities although gained a massive momentum, but the contribution in this regard was mainly from the wealthy people, the lending services were sought by the industries, corporate world and the major portion of society. Initially the banking institute was reluctant to adopt the concept of accountability and transparency, but once the population of the consumers rose, and the banking institute developed linkages with different clients, the bank was forced to ensure that accountability and transparency is practiced in all its form. The economic expansion did not only broaden the horizon for the trade partners, rather the other banking institutes also strengthen and received an equal opportunity for procurement of contracts and opportunities. The trade partners therefore had to intensify the implementation of the plan in the wake of economic expansion, and rising competition. The trade partners developed an strategy, previously when the economic activities were sluggish, the bank focused on the areas where the community sought financial assistance and safeguard for the deposition of their money and other valuables, lately when the technological revolution improved the qualitative and the quantitative standards of living, the bank adopted an entirely different strategy to overcome the needs of the customers, not by offering to them what they require, but by offering to the customers all which they should inherit in this period of technological development, so that the improved quality standards can be availed by the customers. The bank focused from routine operation to an arena of innovation, where the need was never felt but generated to apprise the customers about the qualitative enhancement of life, through different financial schemes (Robert, 2007). Documentary Credit Transaction: Significance The globalization has expanded the network of credit transactions. There were days when the credit transactions were confined within geographical terrains, but the global trade has conceived the concept of international banking. The exchange of economic and trade relations have essentially required the development of the units which shall support and protect the credit transactions. The concept of international banking system evolved with special provisions which secured the monetary interests of the trading units. The associated risks with the documentary credit transactions have been discussed in this paragraph. The documentary credits has realised the needs to the exporters and importers during exchange of goods for payment, and has offered independent assurances to the trading partners. The exporter is offered "irrevocable undertaking" by the financial institutions that the payment shall be deposited in the account of the exporter subject to following conditions i.e. the exporter is able to submit the documents "as stipulated in the credit", and the exporter abide by the terms and conditions of the credit. The importer has to offer certain undertaking, the importer is in actual the applicant of the credit. The importer has to testify to the financial institute that no payment shall be issued under credit unless the terms and conditions are compiled. This mode of transaction has offered smooth and secure passage to the trade partners to invest and procure. The documentary evidence is therefore regarded as "preferred method of payment in International Trade" (Robert, 2007). Documentary Credit Transaction: Risks and Concerns The documentary credit is regarded as complex and complicated mode of financial transactions by the trade partners. However, a general consensus exists among the trade partners that the payment through documentary credits is secure. The government of several countries has encouraged their traders to exchange their goods under documentary credits. The economists have however warned against the risks associated with the documentary credits, i.e. primarily this mode of payment includes several countries into loop, and this has exposed their entire mode of payment accountable to the laws and customs of the various countries. Such exposure on several accounts is considered risky. The major risk has to be experienced by the trade partner. The risk associated with the documentary credit includes the short shipment and shipment of inferior goods in some cases. There are instances when the goods procured by the importers are numerically lesser in number or inferior in quality; however all the necessary documents have been compiled against the terms and conditions of the credit. Under this situation, the importer has to suffer considerable loss on the imported items. Under this condition, the importer has to necessarily establish "the bona fides and the track record of the supplier before entering in to a documentary credit transaction"; such an effort will minimize the losses. The importer has to take smart actions, and has to obtain "credit agency status report on the supplier and also obtaining an independent pre-shipment inspection of the goods". Such cautious approach will protect the financial interests of the importer (Robert, 2007). The documentary credits also involve certain other risks which includes the non-delivery of goods. The exporter might emerge as fraud party, and goods might not be delivered. Under such situation, the importer is liable to pay the financial institution for initiation of documentary credits, and in some cases for release of funds. Documentary Credit Transaction: Secure Mode In trade, there are cases when the goods are received much before the issuance of the documentary credits by the financial institute. Under such situation, the importer is oblige to take delivery of the items under "shipping guarantee which may irrevocably bind the importer to effect payment under the credit irrespective of any discrepancies in the documents received subsequently". Under such condition, unless the goods are released from the port, the port authorities have the right to impose charges on the goods, "rate of charge of the levy may increase with the period for which the goods remain un-cleared at the port", and port authorities have the right to "confiscate goods after the expiration of a stated statutory period". It is therefore important for the importer to prompt the financial institution prior to arrival of shipment at port (Robert, 2007). Under documentary credits, there are cases when the goods are either received in damaged condition or these goods are lost / misplaced during shipment. The documentary credit assists the importer in filing the insurance claims. It is important for the importer to verify that the exporter is liable for the insurance cover while terms and conditions of documentary credits are documented. Such documentation will offer financial relief and protection to the importer. The variance of exchange rate is suspected to influence the documentary credit. In the documentary credits, the type of currency is not essentially of the importer's country. The exchange rate at the time of the issuance of letter of credit migh varies against the rates when the actual deal is conceived. The concept of forward exchange has been therefore conceived. The non-applicability of the forward exchange will put importer liable to submit more money to compensate for the differences of prices; thus reducing the profit margin of the importer. The documentary credits contracts related to forward foreign exchange offer "hedge against this risk where such cover is available to the Applicant although the exchange rate of the cover may turn out to be less attractive than the market rate available"; this format "lock in the prices and associated profits in a transaction" of the importers in cases when the exchange rate waves in the favour of the importer (Jackson, 2000). The beneficiary of the documentary credit is exposed to certain vulnerabilities. The failure on the behalf of the beneficiary to comply against the terms and conditions of the Documentary Credit results in the refusal of the release of money by the financial institutes. However the rights and interests of the beneficiaries are possible through "requisition of amendments to the credit terms if any of the conditions appear to vary from the commercial agreement". The beneficiary shall further secure his financial fortunes by seeking amendments if it is impossible to satisfy any of the conditions related to the release of credit. It is important for the beneficiary to submit the amendments prior to the release of shipment or supply of services (Jackson, 2000). The credibility of the documentary credits is not supported by the mode of payment; rather it is strongly related to the financial standing of the banking institute, and the country from where it operates. The financial fortune of the beneficiary is under severe strain if the financial institute is undergoing economic turmoil, or the country from where it operates lacks foreign reserves. The beneficiary has to consider vulnerabilities including "incidents such as balance of payments difficulties affecting the country of the Issuing Bank and by Government restrictions on transfers of funds outside the country". It is further important for the beneficiary to confirm that the documentary credit is issued by financial institutions. There have been reported cases where non-financial corporations have issued documentary credits to the beneficiaries. It is strongly recommended that the exporters shall refrain from relying on the documentary credit, and shall export their items once trust is developed or restored (Burtless, 1998). The financial communication between the exporter and importer shall be accurate and conclusive. The discussion on the mode of transfer of money against the transfer of goods shall be clearly specified. It is important for both the parties to explore technological avenues for collection of credit information of their clients. The payment terms, and due dates shall be described in crystal clear manner. The proper communication shall always exist between the importer, exporter and financial party. The trade agreement shall be documented, and shall include specific mention of the financial party. The trade document shall be preamble for the documentary credit, and should specify the payment terms, the mode of transfer of funds, and the timeline of release of funds by the financial institute, and the "roleofthefreightforwarderforthetransaction" (Jackson, 2000). The role of the bank and freightforwarder is elaborated by the nature of the payment terms, and mode of fund transfer (Janet, 2006). The financial institution is exposed to certain vulnerabilities associated with the trade partners. The insolvency of the applicant is major threat for the financial institute. This risk can be controlled by taking some security from the applicant against the amount. The banking institute can "retain title to the goods or control over the goods", such legal protection can intact the financial fortune of the banking institute (Jackson, 1998). The general risks associated with the documentary credits include fraud risk, country risk, legal risk and force majeure. However the documentation of the documentary credits shall offer protection and relief to the parties. The fraud risks are primarily related to the documentary credits, under which the payment is released against "non-existent or worthless merchandise" proven through forged documents. The risk is mainly encountered by the credit applicant (Jackson, 1998). The possibility of the forged credit shall not be ignored. The beneficiary shall be the real victim in this case, "beneficiary will have no enforceable claim against the bank named in the credit because either that bank did not in fact issue the credit or the bank named in the credit does not exist". This is followed by the risk related to the economic vulnerability of the country where the bank is located. It is possible that the "performance of the Documentary Credits may be prevented by Government action outside the control of the Parties". The interests of the trade partners can be threatened by the imposition of the "foreign payment restrictions on imports/exports prohibitions after a documentary credit has been issued but before it has been fully performed" (Christine, 2003). The implications attached to the credit transaction have shaken the confidence of the clients. The risk involved with the credit transaction is immense; however this mode is still preferred for its ease. More than USD 1000billion worth of trade dealings is executed through this mode. The letter of credit transaction mode has been designed under Uniform Customs and Practice for Documentary Credits; this mode was initially envisaged by International Chamber of Commerce. The credit transaction through letter of credit has been categorised into revocable and irrevocable. The revocable letters of credit permits the amendment within the trade documents and clauses, these amendments are made without seeking the consent of the exporter. The irrevocable letter of credit offers payment security to the exporter, therefore this mode is commonly preferred by the customers. The credit transaction through letter of credit is designed for huge transaction amounts, and is risk-proof, "as this payment instrument allows the exporter to substitute the credit standing of the buyer with that of his bank, or even another bank outside the buyer's country" (Jan, 2002). The letter of credit is credit assurance by the financial institute to the exporter, however "he beneficiary must meet all of the issuing bank's requirements, thereby triggering the payment". The documentary credit transaction is based upon essential documentations required for the compliance against the letter of credit, "the documents are deemed to represent the goods". In world trade, the cases of compliance against the documentary credit transaction has increased, the contributing factors include the disagreement of the financial institute against the financial standing of the exporter, followed by "cost of documentary discrepancies which is in the order of 113 million per annum" (Christine, 2003). The reluctance of the clients against the credit transaction is further associated with the "behavioural and process risks". The suspected issues related to the annoyance of the customer against the letter of credit include the "errors, omissions, delays, frauds, productivity losses and a dysfunctional work place". All such concerns are independent of the attributes of the documentary credit transaction; rather such concerns are against the service provider i.e. the financial institute (Burtless, 1998). Documentary Credit Transaction: Rules and Regulations The credit transaction system has advanced with the technological advent; however this evolution has brought several challenges for the credit system. This system is exposed to threats and vulnerabilities, and it is essential to develop security system. The technology has permitted the companies to exchange the details of the sales agreements, several modes of payments have germinated. The technology has offered "guidelines by which communication and transmission are acceptable and verifiable" (Janet, 2006). The documentary credit transaction has offered foul-proof mechanism for development of secure business affiliation and credit exchange. During such transactions, it is important to ensure that all the parties i.e. bank, seller and buyer have common understanding, and "therearenobreak-downsinthedocumentaryprocess". The documentary credit transaction system includes details of the payment terms and conditions, the method for the remittance of fund, the role and influence of the financial institute for transaction, and the role of the freightforwarder, and method for the transmittal of documents. The communication process related to the documentary credit transaction includes Uniform Customers and Practice for Documentary Credits and Uniform Customers and Practices. The Uniform Customers and Practice for Documentary Credits were established by InternationalChamberofCommerce. The recent revision of this documentary credit was issued in 2006, and launched as UCP600. This documentary credit has defined "rights and obligations of the various parties in a letter of credit transaction". The UCP600 has explained the appropriate methods to establish standard for communicationandtransmissionofthedocuments (Hudec, 1990). The electronic supplement of UCP was launched in 2002. This document has explained the "generalframeworkofprinciplesfordealingwiththeelectronicdocuments i.e. shipping, custom clearance and baking documents, attached with the letter of credit transactions". UCP500 has defined the approach to "authenticate documents and presentation requirements". The documentary credit transaction system has been further advanced after the launch of SocietyforWorldwideInterbrainFinancialTelecommunication SWIFT. This system has connected the financial institutes and has converged these institutes for communication of the payment information. The system operates upon digital confirmation i.e. "when the bank instructs the advising bank by an authenticated teletransmission to advise a documentary credit, the teletransmission will be considered to be the operative instrument" (Hudec, 1990). The UCP500 constitutes of more than 40 articles, whereas UCP600 has 39 articles. The documentary credit protocol has been reviewed by the Commission on Banking Technique and Practice. The UCP500 has focused upon the "presentation of the documents to the counters of the receiving bank under a letter of credit transaction". This document has been considered as important and requires thorough review and revision under compliance check cycle. Under this article, the financial institute is under compulsion to verify the "documents received by the exporter for compliance against the letter of credit and such compliance shall be determined by international standard banking practice as reflected in these articles". The compliance of UCP500 is monitored by International Standard Banking Practice. The UCP600 has ensured the compliance of documentation of credit transactions, the financial institutes have been required to "adopt international standard banking practice" (Razeen, 2006). The documentary credit transactions have been exercised mostly through letter of credit, this mode is popular among the traders involved in export businesses. The mode of payment has offered "considerable advantages" to the parties, especially with reference to the payment mechanism, and financial safeguards. The letter of credit is regarded as "documentary in nature and independent of the sale contract because payment is made in return for shipping documents rather than the goods themselves"; the transaction is therefore safe, secure and fool-proof. Under this mode of payment, the "importer can reassure him or herself that the correct goods have been placed in the hands of a carrier by, for example, demanding not only a shipped bill of lading, but also an inspection certificate signed by an independent and reputable third party" (Razeen, 2006). This mode of shipment is popular among the clients involved in multi-million dollar trade. This mode of payment is considered to be expensive, and are "costly to arrange and consequently traders who deal regularly with each other in politically stable countries may well prefer a cheaper trade financing technique". The documentary credit transaction accounts for merely 10percent of the world trade volumes. The letter of credit is handled under stringent monetary policy, therefore minor discrepancy often result in the disqualification or rejection of the credit documents. The discrepancy and rejection of the credit note is charged by the financial institute from the trade partners under heavy fines, and in some cases by the country under trade embargo. The reluctance of the traders resulted in certain amendments within the UCP rules and regulations. The intent of these regulations was to "satisfy the expectations not only of traders but also banks, carriers and other third parties". The UCP regulations provided "set of privately created rules which are not comprehensive and which, of necessity, are supplemented by national rules". Under the theory of risk management, it is important to document the credit transaction, and the release of payment shall be subject to the confirmation of the importer and the bank. The major reluctance which the business leaders have expressed against the documentary mode of credit transaction is the imposition of high charges; the traders of United Kingdom have reported incurred cost of 113 million per annum against this mode of payment". The documentary credit transaction under letter of credit is "an important instrument of finance that is particularly suited to international business transactions and it is vital that the rules that govern such transactions are acceptable to traders and financiers alike". The evolving and changing patterns and mode of trade have been covered by UCP500; therefore the traders are in agreement with the existing regulations of UCP, except for the high cost of payment mode. The payment risks have been reduced and eliminated through this mode of payment, and the documentary credit transaction has offered "environment of certainty and stability" to the trade partners (Dejan, 2003). Conclusion The unit known as a documentary credit transaction will be crucial for the creation of different policies, aimed at the accomplishment of "asset protection, estate planning, and privacy benefits" (Christian, 2003). The documentary credit transaction has been regarded as the legal arrangement, and has "certain essential characteristics". The documentary credit transaction is responsible for the administration and execution of the terms and conditions related to documentary credit transaction. A documentary credit transaction is registered to one or more trade partners, "who are responsible for administering and carrying out the terms of the documentary credit transaction", "the recipients are those who are entitled to documentary credit transaction income or principle either currently or at some time in the future". As per the acceptable practices, the documentary credit transaction is a formal and legal document between exporter and importer. As per the contents of the UCP500, the documentary credit transaction is issued against certain assets by the importer, "documentary credit transaction will hold those assets for the benefit of the named beneficiaries". The documentary credit transactions are enormously supple in form and almost any "asset protection and estate planning goal can be accomplished by an attorney who is knowledgeable and experienced in this field". The implementation and execution of the "creative documentary credit transaction strategies, the planning opportunities for achieving tax savings and asset protection advantages" are unrestricted. The major objective of documented credit transaction is to manage property "for trade partners" (Christian, 2003). The evaluation of the current liabilities is given considerable focus, the reason being that it helps in the assessment of the company's financial standing and borrowing position. The worth of the current assets is crucial in the determination of the financial stability of the company; the influence of the non-current items is minimal and is generally not taken into consideration due to its volatile nature and market worth. The net worth of the non-current Items is not significant, but such commodities can improve the standing of the company on the basis of asset accumulation. The reasonable assessment of the company is based upon the capital it has secured, and the generated revenue. The interests of the company are secured through the mode of trade undertaken by the company; the mode of payment by the company should protect the financial interests of the respective parties (Yeliz, 2002). References 1. Roberto Bergami. 2007. Will the UCP 600 Provide Solutions to Letter of Credit Transactions International Review of Business Research Papers. Vol.3 No.2. 2. Janet Ulph. 2007. The UCP 600: documentary credits in the 21st century. Journal of Business Law. 3. 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