If you work in international trade or shipping, chances are you've come across the phrases "cash against documents" and "letters of credit" more than once, as both of these documents are commonly used as payment methods in trade. Though they ultimately serve the same purpose, these forms of documentary credits and documentary collections differ in terms of utility, security and even costs. The devil may be in the details, but each one has a clear utility and caters to different types of trade relationships.
About Letters of Credit
Letters of credit essentially substitute the credit of the bank for that of the customer. A commercial letter of credit facilitates trade while a standby letter of credit acts as a secondary payment mechanism (a form of payment that steps in when the primary payment fails).
These letters are a contractual agreement between a bank acting on behalf of its customer and a beneficiary authorizing the bank to make a payment or honor withdrawals made under credit. Typically, they include information such as the given amount of money, the goods or services purchased and an outline of time limits in which payment may be redeemed.
About Cash Against Documents
Like a letter of credit, cash against documents step in during trade transactions where straight-up credit isn't available, making it another useful tool for international trade. With cash against documents, the purchaser pays for goods before receipt of them while a third party holds the shipping and title documents for the goods until payment is received. Much like holding money in escrow, this serves as a form of insurance to protect the seller.
Cash against documents are well suited for overseas trade, as it guarantees payment for exporters. It also helps importers ensure that they get exactly what they purchase without having to deal with the complicated cross-border transactions often needed to correct an international purchase or shipping mistake.
How They Differ
Letters of credit are usually negotiable and can be either revocable or irrevocable. In order to receive payment on a letter of credit, the beneficiary must present a draft and the documents specified by the letter itself. Because banks play a key role in letters of credit, letters of credit tend to be more secure but also more costly to obtain, making them a good choice for two parties who are new to doing business with each other.
In the case of cash against documents, banks have no responsibilities against exporters. This makes cash against documents a little easier to deal with in operational terms and much less costly to obtain than letters of credit – which stand as one of the most expensive payment methods for overseas trade – but doesn't offer quite as much security. In contrast to letters of credit, cash against documents are well suited to partners who have a history of trade together, a mutual trust and confidence in or familiarity with the country of destination.
Dan's decade-long experience as a freelance writer and small business owner has seen him contribute to financial publications including Chron.com, Zacks.com, MSN Money, Fortune, Motley Fool and others.