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The documentary credit plays a significant role in international trade, particularly in the form of a letter of credit, where the buyer and seller are in different countries. The distance between them creates trust issues, making it difficult to rely on each other.
Dealing with someone who is unknown, and unseen can be risky, especially when the transaction involves large sums and expensive goods.
Both parties are often reluctant to engage unless they are assured their positions are protected.
This challenge applies not only to customers of conventional financial institutions but also to Islamic financial institutions, highlighting the need for an alternative that is Shariah-compliant to meet the needs of clients and the industry.
Documentary credit is defined as a written undertaking by the bank (the issuer) to the seller (the beneficiary), made at the request of the buyer (the applicant or orderer).
It is issued by the bank either for its own use or on behalf of the buyer, where the bank commits to paying a specified amount within a certain period, provided the seller presents documents for the goods that meet the stipulated conditions.
In brief, a documentary credit is an undertaking by a bank to pay subject to conformity of the documents to the contractual instructions.
There are several stages of its working mechanism, below is its detail:
i- The stage of concluding a credit contract: The stage of concluding a credit contract occurs before the actual contract, with the seller typically stipulating that payment will be made through a letter of credit.
ii-The stage of requesting the opening of the credit: At this stage the buyer approaches the bank and ask for the opening of documentary credit so that the seller can be notified.
iii-The stage of opening the credit and notifying the seller: At this stage the bank issue the documentary credit and send it to the buyer, either directly or through intermediary.
iv-The stage of executing the credit: At the stage of executing the credit, the beneficiary presents the documents to the bank, which examines them for compliance with the credit conditions.
If the documents are in order, the bank accepts them and delivers them to the buyer upon payment or commitment to pay; otherwise, the bank may accept, reject, or request amendments to the documents.
v-Coverage by correspondent: if more than one bank participates in the execution of the credit, the accounts are settled in accordance with the terms of coverage agreed upon between the banks.
There are various types of documentary credit, each with its own specifications. Below are some of the most important types:
Revocable documentary credit can be cancelled or amended without the beneficiary's consent, whereas irrevocable documentary credit cannot be changed or cancelled without the beneficiary's approval.
In this type of documentary credit the beneficiary is entitled to request the executing bank to make the credit available, partially or totally to another beneficiary or beneficiaries.
It means that the issued credit is guaranteed by another credit.
Which means the beneficiary can submit new documents for the new request within the limit of credit and during its permissibility.
It is the type of credit in which the second bank (usually in the seller country) guarantees payment in addition to the issuing bank guarantee and in non-confirmed guarantee is when only the issuing banks guarantee’s payment and there is no additional guarantee from another bank.
Sight documentary credit means that the payment will be made immediately on the presentation of the documents, and the time documentary credit means that the payment will be made later, usually after a specified period or at maturity after the presentation of the documents.
The core difference between confirmed and non-confirmed documentary credit is that in a confirmed documentary credit, the payment of the credit is guaranteed by another bank, usually located on the seller's or beneficiary's side.
In a non-confirmed documentary credit, there is no additional guarantee for the payment of the credit; only the issuing bank provides the guarantee.
As per the AAOIFI statement on documentary credit, it is permissible for Islamic financial institutions to issue documentary credits for clients, as it involves two elements.
The first is the procedural process, such as document preparation and examination, which falls under the category of an agency contract.
The institution may charge actual expenses incurred in issuing the documentary credit. It is also permissible to charge a fee for the services, whether as a lump sum or a percentage of the credit, provided the duration of the credit is not considered in determining the commission.
The second element is the guarantee, where it is not permissible for the institution to factor in the guarantee when charging or determining the fee.
For more details, please refer to AAOIFI Standard No. 5: Guarantees
Documentary credit typically involves a bank guaranteeing payment in exchange for documents, and it is often based on interest in conventional financial institutions.
However, there is a Shariah-compliant alternative for it in Islamic financial institutions, as briefly discussed in the above paragraphs.
In contrast, Islamic trade finance instruments are solely based on Islamic principles, avoiding invalid, void, and impermissible factors from a Shariah perspective.
Read more about: Understanding Qabd: The Concept of Possession in Islamic Jurisprudence
References:
1. https://aaoifi.com/ss-14-documentary-credit/?lang=en
2. https://aaoifi.com/ss-5-guarantees/?lang=en .
3. Othman, A. A., Hashim, R. C., & Aziz, A. A. (2010). An overview of Shari'ah issues regarding the application of the Islamic letter of credit practice in Malaysia. ISRA International Journal of Islamic Finance, 2(2), 37-66.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
