Industrialization and globalization are commonly used terms in world trade nowadays. Industrialization began in the eighteenth century in Britain, while large-scale globalization occurred only in the nineteenth century.
Among them are the Letter of Credit and the Documentary Collection, which are confused as the same but have considerable differences.
Key Takeaways
- A letter of credit is a bank-issued guarantee ensuring payment to a seller on behalf of a buyer if certain conditions are met, providing security for both parties.
- Documentary collection is a trade transaction in which the seller’s bank collects payment from the buyer’s bank in exchange for shipping documents, with no payment guarantee.
- Credit letters offer sellers more protection by guaranteeing payment, while the documentary collection is less secure but simpler and less costly.
Letter of Credit vs Documentary Collection
The difference between a Letter of Credit and a Documentary Collection is that in the former case, the bank has to remit the dues to the exporter. In the latter case, on the other hand, the bank holds no such responsibility.
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It has the advantage that if the importer cannot remit for the imported goods, his bank has to bear the obligation to pay the exporter. A Letter of Credit is a widely used document in international trade.
A Documentary Collection is a document issued at the exporter’s request from his bank. The goods are delivered to the importer only when he clears the dues and fetches the consignment documents.
Comparison Table
| Parameter Of Comparison | Letter of Credit | Documentary Collection |
|---|---|---|
| Definition | A Letter of Credit is a document issued by the importer’s bank to the exporter’s bank that guarantees the exporter complete remission of the export amount. | A Documentary Collection is the process through which the exporter’s bank requests payment from the importer’s bank by sending documents detailing the transaction amount and list of items. |
| Issuing Authority | The importer’s bank is the issuing authority for the Letter of Credit. The importer requests a bank in his country to issue the letter. | The exporter’s bank is the issuing authority for the Documentary Collection. The exporter submits the relevant documents to a bank in his country. This bank then notifies the importer’s bank about the commercial aspects. |
| Charges Incurred | The charges incurred on the importer by the issuing bank are generally higher and measured as a percentage of the Letter of Credit amount. | The charges incurred on the exporter while issuing Documentary Collection are generally lower and minimal compared to Letter of Credit costs. |
| Preferable Usage | They are preferred when the importer and exporter belong to distant countries and have apprehensions regarding the economic conditions of each other. | Preferred when the importer and the exporter know each other very well and there is greater confidence that there will not be any breach of trust. |
| Level of Security | Provides a higher level of security in international transactions as the responsibility of remittance lies on the importer’s bank. | Not considered a safe tool for international transactions as the importer is at a higher risk of fraud. |
What is Letter of Credit?
A Letter of Credit (LC)is also called a Documentary Credit, Banker’s Commercial Credit, or a Letter of Undertaking (LoU). It is a formal document issued by one bank to another.
It is widely used in international trade and guarantees that a seller will get money for his goods. It also acts as a utility to withdraw cash from banks in foreign countries.
The importer’s bank issues the Letter of Credit after seeking collateral from the importer. If the importer fails to remit the dues in the future, the bank has to pay the exporter on his behalf.
What is Documentary Collection?
A Documentary Collection is a process through which the exporter’s bank retrieves payment from the importer’s bank in exchange for shipping documents.
The Remitting Bank, the Collecting Bank, forwards these documents to the buyer’s bank. The Collecting Bank informs the buyer about the papers and hands them to the buyer when he remits the dues.
They are of two types – documents against payment (D/P) and documents against acceptance (D/A).
Although documentary collections are cheaper than letters of credit, they are less secure. They are usually preferred only when the exporter and the importer have a stable and credible relationship.
Main Differences Between Letter of Credit and Documentary Collections
Both letters of credit and documentary collection are stakeholders in international trade. The bank is the issuing authority in both cases.
There are, however, many differences between the two. These are:
- The letter of credit costs more to be issued, whereas documentary collection is cheaper.
- A letter of credit is preferred when there is a risk in trade due to geographical strains, while a documentary collection is selected when the traders have solid and credible ties.
- https://muse.jhu.edu/book/25174
- https://www.jewishgen.org/ukraine/files/CAHJP-microfilm-collection.pdf
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1020705
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
