The documentary draft, like the letter of credit, is used to protect the interests of both buyer and seller. Both methods require that payment be made based on the presentation of documents transferring ownership of goods and documents giving evidence that specific steps have been taken such as shipping, obtaining necessary certificates and so on.
A documentary draft, sometimes called a bill of exchange, can be paid:
- Upon presentation of documents, i.e., a sight draft;
- At a later date, i.e., a time draft (after x days) or date draft (at a specific date).
Banks involved in handling documentary drafts charge a fee that is usually a percentage of the value of the draft. A draft fee is usually much lower than a letter of credit fee. The exporter typically expects the buyer to pay the charges for the documentary draft.
A sight draft is used when the seller wants to retain title to the shipment until it reaches its destination and payment is made. Before the shipment can be released to the buyer, the original bill of lading must be properly endorsed by the buyer and returned to the carrier. As a practical matter, the bill of lading is usually endorsed by the seller and sent via the seller's bank to the buyer's bank. It is accompanied by the sight draft, invoices, and any other supporting documents that are required by either the buyer or the buyer's country. The buyer's bank notifies the buyer when it has received these documents. As soon as the draft is paid, the buyer's bank turns over the bill of lading which allows the buyer to claim the shipment.
The sight draft still entails risk. If the buyer decides not to pay the draft, the seller is responsible for disposing of the goods that he has already transported to another country.
Time Drafts and Date Drafts
The seller uses a time or date draft to extend credit to the buyer. In this case, payment is due at some specified time (30 days after acceptance) or date after the buyer accepts the draft and receives the goods. By signing and writing 'accepted' on the draft, the buyer is formally obligated to pay within the stated time, creating a situation called a trade acceptance. The acceptance can be kept by the seller until maturity or sold to a bank at a discount for immediate payment. This debt instrument is also a legal document that gives the seller certain protections. If the buyer defaults or delays payment at maturity, the seller has a stronger case in court.
When to Select Documentary Collection
Sellers are comfortable using documentary collection when:
- The seller and the buyer know each other to be reliable.
- There is no doubt about the buyer's willingness or ability to pay.
- The political and economic conditions of the buyer's country are stable.
- The importer's country does not have restrictive foreign exchange controls.
The documentary collection procedure is often a transitional payment mechanism when the seller is willing to stop requiring prepayment from buyers they have built trust with.