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. International trade has flourished since then, and countries all over the world have welcomed new opportunities for their business folk. However, this has brought credibility issues for both the exporter and the importer.
International organizations have, therefore, brought significant safety measures in this regard. Among them are the Letter of Credit and the Documentary Collection, which are confused as the same but have considerable differences.
Letter of Credit vs Documentary Collection
The main 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.
A Letter of Credit is a document issued at the request of the importer of goods from his bank. It has the advantage that in case the importer is not in a position to remit for the imported goods, his bank has to bear the obligation to pay to the exporter. A Letter of Credit is a widely used document in international trade.
A Documentary Collection is the document issued at the request of the exporter from his bank. The goods are delivered to the importer only when he clears the dues and fetches the consignment documents. The Documentary Collection is less popular when compared to a Letter of Credit.
Comparison Table Between Letter of Credit and Documentary Collection (in Tabular Form)
| 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 full 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 in comparison to Letter of Credit costs. |
| Preferable Usage | Preferred when the importer and exporter belong to very distant countries and have apprehensions regarding the economic conditions 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 or a 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 provides a guarantee to a seller that he will get money for his goods. It also acts as a utility to withdraw cash from banks in foreign countries.
When a trader and an importer finalize their contract, the importer requests a bank in his country to issue a Letter of Credit. This bank apprises the exporter’s bank about the contract.
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. There are many types of Letters of Credit, such as commercial, standby, revolving, and others. The International Chamber of Commerce supervises these operations. The Letters of Credit have become electronic nowadays. Albeit they levy extra costs, they are considered very secure.
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. It is of particular advantage to a seller.
When the trade contract between the seller and buyer gets finalized, the seller requests a bank in his country to issue a Documentary Collection by submitting documents giving details of his consignment. The seller’s bank is also called the Remitting Bank.
The Remitting Bank forwards these documents to the buyer’s bank, which is also called the CollectingBank. The Collecting Bank informs the buyer about the documents 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).
Documents against payment are documentary collections when on sight payment is made. Documents against acceptance are the ones in which the payment date is in the future. Although documentary collections are cheaper than the letters of credit, they are also 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 Collection
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:
- A letter of credit is an official document that provides a guarantee of payment to a seller. On the other hand, a documentary collection gives the privilege to a buyer to reject the consignment if it does not meet the quality standards.
- The importer’s bank issues the letter of credit, whereas the exporter’s bank issues the documentary collection.
- The bank takes the responsibility to pay to the exporter if the importer is not able to do so in the letter of credit facility. On the other hand, the bank holds no such responsibility in the documentary collection facility.
- 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 the geographical strains, while a documentary collection is preferred when the traders have strong, credible ties.
Conclusion
As international trade is flourishing, trade organizations around the world have welcomed the move with numerous privileges to the investors. In India, too, the government has loosened many trade laws to attract investors.
Facilities such as the letter of credit and documentary collection inculcate a sense of security in the traders that they wouldn’t experience malpractices. Since banks are trustworthy institutions, their utilization in safeguarding trading practices relieves emerging traders of apprehensions.