Introduction to Trade Finance & Documentary Credits

CDCS Master Series – Article 1

1. Why Trade Finance Exists

International trade appears simple: a seller exports goods, a buyer pays money. In reality, this simple exchange is filled with risks. The buyer and seller are often located in different countries, operate under different legal systems, use different currencies, and may have never met before.

Consider a Bangladeshi garment exporter shipping products to a buyer in Europe. The exporter worries: Will the buyer pay after receiving the goods?
The buyer worries: Will the exporter ship the correct goods on time and according to contract?

Between shipment and payment lie multiple risks:

• Payment risk
• Performance risk
• Country and political risk
• Foreign exchange risk
• Fraud risk
• Documentation risk

Trade finance exists to manage these risks. It provides mechanisms through which banks step in to facilitate trade by controlling payment, documents, and risk allocation. Without trade finance, global trade at today’s scale would be nearly impossible.

2. What Is Trade Finance?

Trade finance refers to the financial products, services, and processes provided by banks and financial institutions to support domestic and international trade transactions.

Trade finance includes:

• Payment mechanisms
• Risk mitigation tools
• Financing solutions
• Document handling and examination
• Compliance with international rules and regulations

Importantly, trade finance is not only about lending money. In many cases, banks do not finance at all — instead, they manage documents and payment conditions, which is the backbone of documentary credits.

3. Major Trade Settlement Methods

To understand documentary credits, one must first understand the full spectrum of trade settlement methods.

3.1 Cash in Advance

How it works:
The buyer pays the seller before goods are shipped.

Risk allocation:

• Buyer: High risk
• Seller: No payment risk

Example:
A new Bangladeshi importer pays a foreign supplier 100% in advance through a telegraphic transfer (TT). If the supplier fails to ship goods, recovery is difficult.

Usage:
Rare in established trade relationships; common when seller has strong bargaining power.

3.2 Open Account

How it works:
The seller ships goods first; the buyer pays later (e.g., 30, 60, or 90 days).

Risk allocation:

• Buyer: Low risk
• Seller: High risk

Example:
Large multinational retailers often purchase goods from long-term suppliers on open account terms.

Usage:
Common in developed markets with strong trust and legal enforcement.

3.3 Documentary Collections (URC 522)

How it works:

• Seller ships goods
• Documents are sent through banks
• Buyer receives documents only after payment or acceptance

Key point:
Banks do not guarantee payment.

Risk level:
Medium risk for both parties.

Example:
Documents against Payment (D/P) — buyer may still refuse to pay.

3.4 Documentary Credits (Letters of Credit)

How it works:
A bank undertakes to pay the seller provided that the seller presents documents strictly complying with the credit terms.

Risk allocation:

• Buyer: Controlled risk
• Seller: Strong payment assurance

This method offers the highest level of security and is the most structured settlement method in international trade.

4. What Is a Documentary Credit?

A documentary credit, commonly known as a letter of credit (LC), is a conditional undertaking by a bank to make payment to a beneficiary, provided that the beneficiary presents documents that strictly comply with the terms and conditions of the credit and applicable rules.

Under UCP 600, a documentary credit is:

• Irrevocable
• Independent of the underlying sales contract
• Payable against documents, not goods

Key principle:
👉 Banks deal with documents, not goods or services.

5. Why Documentary Credits Are So Important

Documentary credits solve the most critical problems in international trade:

For this reason, documentary credits remain dominant in many emerging economies, including Bangladesh.

6. Core Principles of Documentary Credits

Understanding these principles is essential for passing CDCS.

6.1 Principle of Independence

A documentary credit is separate from the underlying sales contract.

Even if:

• Goods are defective
• Contract terms are breached

The bank must honour the credit if documents comply.

📌 UCP 600 Article 4

6.2 Principle of Autonomy

Banks deal only with documents, not with:

• Goods
• Services
• Performance

📌 UCP 600 Article 5

This principle protects banks from commercial disputes.

6.3 Principle of Strict Compliance

Documents must strictly comply with LC terms.

• “Almost correct” ❌
• “Commercially acceptable” ❌
• “Documentarily compliant” ✅

Example:
LC requires “100% Cotton Shirts.”
Invoice states “Cotton Shirts.”
→ Discrepancy.

This principle is one of the most tested areas in CDCS exams.

7. Role of Banks in Documentary Credits

Banks do not act as buyers or sellers. Their role includes:

• Issuing payment undertakings
• Examining documents
• Managing operational risk
• Ensuring regulatory compliance

For CDCS candidates, it is crucial to think like a banker, not like a trader.

8. Historical Evolution of Trade Finance

Trade finance evolved from personal trust and merchant guilds to formal banking instruments. As global trade expanded, banks began issuing written payment undertakings to reduce risk.

The establishment of the International Chamber of Commerce (ICC) standardized trade practices through rules such as:

• UCP (Uniform Customs and Practice)
• ISBP (International Standard Banking Practice)

This standardization enables banks worldwide to operate under a common framework.

9. Documentary Credits in the Bangladeshi Context

Bangladesh remains heavily dependent on documentary credits due to:

• Exchange control regulations
• Import policy requirements
• Export incentive structures
• Counterparty risk considerations

Key LC-driven sectors include:

• Readymade garments (RMG)
• Textile raw materials
• Capital machinery
• Fuel and commodities

For Bangladeshi professionals, documentary credit knowledge is a core career skill, not an optional specialization.

10. Typical Documentary Credit Transaction Flow

1. Buyer and seller sign sales contract
2. Buyer applies for LC
3. Issuing bank issues LC
4. Advising bank advises LC
5. Seller ships goods
6. Seller presents documents
7. Bank examines documents
8. Payment made if compliant

Every step after issuance revolves around documents, not goods.

11. Advantages and Limitations of Documentary Credits

Advantages

• Strong payment security for exporters
• Shipment control for importers
• Internationally standardized rules
• Facilitates trade financing

Limitations

• Higher cost
• Document-intensive
• Strict compliance can cause disputes

Balanced understanding is essential for both exams and real banking decisions.

12. Banker’s Tip 💡

Many CDCS candidates fail because they judge fairness instead of compliance.
Always ask: “Do the documents comply?” — not “Is the deal fair?”

13. Common Exam Mistakes ❌

• Confusing goods with documents
• Ignoring independence principle
• Applying contract logic instead of UCP logic
• Overlooking strict compliance

14. Quick Revision Checklist ✅

• Purpose of trade finance
• Settlement methods comparison
• Definition of documentary credit
• Core LC principles
• Role of banks

15. CDCS-Style Practice MCQs

Q1. Banks under a documentary credit deal primarily with:
A. Goods
B. Services
C. Documents
D. Contracts
Answer: C

Q2. Which settlement method offers the highest payment security to the exporter?
A. Open account
B. Documentary collection
C. Cash in advance
D. Documentary credit
Answer: D

Q3. If documents comply but goods are defective, the issuing bank should:
A. Refuse payment
B. Inspect goods
C. Honour the credit
D. Seek court order
Answer: C