How do Documentary Credits make international payments secure? | Article – HSBC VisionGo
When it comes to international trade, foreign trading companies may run into these situations: when a buyer and seller trade with each other for the first time or in the early stage of their partnership, the importer (buyer) may worry that the supplier (seller) may not deliver goods on time; while the seller may also worry about the buyer delaying or refusing to pay after the goods have been shipped. When buying goods that need to meet strict quality and specification requirements, such as medical equipment, vehicle and electronic parts, etc., the buyer may also be worried about paying for goods that may not entirely meet the required standard.
How can the seller and the buyer build trust between them and ensure the smooth operation of their business dealings?
As the most common payment method in foreign trading business, this is where the Documentary Credit (DC) comes into play. Having the bank as the guarantor for the buyer and the seller, a DC helps ensure the smooth receipt of payment and delivery of goods.
With Hong Kong being one of the freest trading ports, many companies hope to leverage on the city’s edge in finance and logistics to start or expand their import/ export trading businesses. This article introduces how the DC works and its advantages, and more importantly, how a business may set up a DC through its Hong Kong bank account, and precautions to keep in mind.
What is a Documentary Credit (DC)
A Documentary Credit (DC) is a written document through which a buyer (applicant) entrusts its bank (issuing bank) to undertake to pay the seller (beneficiary) for goods or services within a prescribed time limit as long as clearly defined terms and conditions have been met.
There is no standard format for DC documents. It is usually written in English, and the terms are written according to the “Uniform Customs and Practice for Documentary Credits (UCP 600)”, and include the following:
- Description of the DC: the type, nature, number, amount, currency, date of application, expiry date and place, beneficiary information, etc.
- Description of goods: the name, quality, specification, quantity, packaging, transportation mark and unit price
- Transportation requirements: shipment deadline, transportation method, whether the shipping cost should be prepaid and transshipment, etc.
- Documents required: the type, name, content and number of copies required
- A statement that the issuing bank promises to pay the beneficiary
- Additional conditions, if any.
Referring to HSBC as an example, you may click here for the DC application form to understand what kind of information you will need to provide, or ask your Relationship Manager. In general, it is stipulated that the buyer must first transfer the payment to the DC issuing bank, and eventually for the issuing bank to make the payment on behalf of the buyer.
The seller will receive the payment if it submits the documents as stipulated in the DC via its own bank to the DC issuing bank. The buyer will receive the goods if it makes payment to the issuing bank in order to redeem the seller’s documents, which the buyer can then present to the logistics company to claim the goods.
Before applying for a DC, the applicant should open a trade account and get the capital ready
First, the DC applicant will need a Hong Kong business banking account, and will need to have a trade account set up before they can apply for a DC issued by a Hong Kong bank. Different banks have different requirements for opening a trade account.
Taking HSBC as an example, a company can apply for a business integrated account and a trade account at the same time, but the trade account can only be used after the application for the integrated banking account is approved.
Since third-party transfer cannot be done through a trade account, and usually staff would receive orders and sign contracts directly, business owners are rather relaxed about using the staff’s contact details and signature for the trade account. Usually, because of business needs, it is rather easy for foreign trading companies to operate a trade account.
Meanwhile, the buyer will need to get the capital ready to apply for a DC. This is usually done through these two ways:
- Full payment, i.e. providing cash deposit as collateral at a ratio of 1:1, where the buyer first transfers the payment to the bank, as described above.
- Partial payment, i.e. applying for a line of credit from the bank with collaterals, so there is no need to transfer any payment to the bank, or only partial transfer of the payment is required. In general, the full payment is made after the goods are sold. This improves the cash flow for businesses. Financial statements will have to be provided to the bank for approval.
Among the types of collaterals, properties in Hong Kong are the most common, in which case a financial statement and bank approval are also required. The line of credit can be as high as 100% the market value of the property. Businesses applying using other collaterals, such as equities, bonds or others may be granted a line of credit of a different amount. They will have to negotiate with the bank on the details.
If a company has no collateral to provide and would like to take out an unsecured loan, they may consider applying for the “80% Guarantee Product under the SME Financing Guarantee Scheme” (SFGS) launched by the Hong Kong government.
For example, if a company would like to apply for a line of credit of HKD10 million, the government will guarantee 80% of this amount, which means the bank will advance HKD8 million for the payment of goods within the validity of the line of credit. For the remaining 20%, the company will have to negotiate with the bank whether the company should first pay for part of the HKD2 million or the full amount. Eligible companies may make an application to their bank.
For HSBC account holders, from now until 30 June 2022, successful applicants of “80% Guarantee Product under the SME Financing Guarantee Scheme” can enjoy full subsidy for the first year and 50% subsidy for second year on guarantee fee. Subsidy offer is up to HKD50,000 for each successful applicant. Click here to find out more about the “80% Guarantee Product under the SME Financing Guarantee Scheme” provided by HSBC.
How to apply for a DC through your Hong Kong bank?
With all these ready, the buyer can now arrange a DC for a specific trade contract, and receive the goods and make payment with peace of mind!
Taking HSBC as an example, here are the steps for setting up a DC in Hong Kong:
- Buyer and seller sign a trade contract, and stipulate that payment be made by a DC
- With the trade contract, the buyer informs HSBC (issuing bank) to set up a DC, with the seller being the beneficiary
- HSBC issues a DC to the seller’s bank (advising bank)
- When the advising bank receives the DC, it will advise the seller that the DC has been issued. The seller will then ensure it can fulfil the conditions stipulated in the DC, and ship the goods.
- After shipping the goods, the seller obtains the associated original documents from the logistics company and prepares the required documents
- Through its advising bank, the seller will submit the documents to HSBC to remind the bank to initiate the payment
- HSBC will verify the documents according to the DC. If the documents fulfil the requirements stipulated in the DC, HSBC will inform the buyer to pay
- After receiving the payment, HSBC will pass the documents to the buyer for receiving the goods, and at the same time pay the advising bank, which will finally make the payment to the seller.
There are many types of DCs that cater to different business needs, including Documentary Credit/ Clean Documentary Credit, Sight/ Tenor Documentary Credit, Back-to-Back Documentary Credit and Transferable Documentary Credit, etc. Businesses can enquire with the issuing bank about which DC works best for them, considering their particular circumstances such as their particular trading relationship, payment schedule and requirement, and whether there is a need for another bank to guarantee the payment.
What to bear in mind while using a DC?
Choose your trading partner carefully
Since a DC is not attached to a trade contract, and payment is made on presentation of the documents but not the physical goods, as long as the the documents presented by the seller fulfil the requirements of the DC, the issuing bank is required to fulfil its responsibility to pay.
Therefore, the buyer must reach out to and get to know its partner through proper channels (e.g. attending site visits and import/ export expos) in order to avoid trading with companies with unknown quality and bad credit record.Before signing a contract, the seller should also entrust relevant bodies to conduct credit investigation into the partner, and understand DC frauds and the relevant laws and regulations in order to avoid being defrauded.
Arrange the issuing method and conditions of the DC cautiously
The trade contract is the foundation of a DC. In a trade involving a DC, the seller must deliver the goods strictly in accordance with the conditions stipulated in the DC in order to receive the payment.
Therefore, when drafting a trade contract, both parties must arrange the requirements and conditions listed in the DC cautiously. In particular, the seller must be totally confident in fulfilling the DC conditions. For example, after signing the trade contract, the DC should be arranged as soon as possible, to allow the seller sufficient time to arrange production and transportation, etc.
In addition, payment by DC is based on the principle that the documents comply with the credit terms, and that the documents must be consistent. In other words, the issuing bank will make the payment as long as the content in the documents provided by the seller matches exactly the requirement stipulated in the DC, including punctuation and letters.
Amending the content of a DC
Only the buyer has the right to decide whether to amend a DC, and only the seller has the right to decide whether to accept the amendments. The seller can only fully accept or reject the amendments, and partial acceptance of the amendments will be invalid. At the same time, it must be stated clearly who will bear the cost of the amendments, which is usually decided according to where the responsibility lies.
The most basic fee is the one for applying for a DC. For HSBC’s revocable DC, currently the minimum charge is HKD500. If you set up a DC through HSBC internet banking or HSBCnet, you will also be entitled to a HKD50 commission discount.
Amending a DC will incur extra charges. It is worth noting that fees and special offers can be adjusted anytime, so please ask your issuing bank for details about the fees.
Documentary Credit protects the rights of both buyer and seller, ensuring the smooth receipt of goods and payment. Nevertheless, considering the stringent requirement for all the information on the documents to be accurate, when the buyer and the seller sign a trade contract and set down the requirements of a DC, they must ensure that they confirm the terms and sign the contract only if they are entirely confident that they will be able to meet the goods delivery and payment requirement.
In addition, the seller can use a DC to apply for financing, i.e. Export DC Bill Negotiations, in order to use their capital with more flexibility. We will introduce more types of trade finance in upcoming articles.
Reminder: “To borrow or not to borrow? Borrow only if you can repay!”