Name : Hammas Alyas

Roll no : 04

Subject : Shariah Standards 2

Class : IEB 8th

Semester : 8th

Assignment no : 01

Submitted to : Mam Rabiya

Topic : Documentary Credit

Definition:
A documentary credit, also known as a letter of credit, is a financial instrument
used in international trade transactions. It is a written commitment by a bank on
behalf of the buyer (importer) to pay the seller (exporter) a specified amount of
money, provided that the seller meets certain conditions outlined in the credit.
Types Of Documentary Credit:
1. Irrevocable Letter of Credit: Once issued, this type of LC cannot be altered
or canceled without the agreement of all parties involved. It provides a high
level of security for both the buyer and seller.
2. Revocable Letter of Credit: This can be altered or canceled by the issuing
bank at any time without prior notice to the beneficiary. It is less commonly
used due to the lack of security it offers the seller.
3. Confirmed Letter of Credit: This LC is backed by a second bank (usually in
the seller’s country) that guarantees payment if the issuing bank fails to do so.
It provides additional security to the seller.
4. Unconfirmed Letter of Credit: Only the issuing bank provides the guarantee
of payment. The seller does not have the added security of a second bank's
confirmation.
5. Standby Letter of Credit: This serves as a backup payment mechanism if the
buyer fails to fulfill their contractual obligations. It is often used as a
guarantee for various types of performance and payment obligations.
6. Revolving Letter of Credit: This allows for the credit to be automatically
renewed or reinstated after each drawing, up to a specified amount and period.
It is useful for ongoing business relationships where multiple transactions are
expected.
7. Transferable Letter of Credit: This allows the beneficiary to transfer part or
all of the credit to one or more secondary beneficiaries. It’s often used in
transactions involving intermediaries or agents.
8. Back-to-Back Letter of Credit: This involves two separate LCs. The first LC
is issued by the buyer’s bank to the seller, and the seller then uses that LC as
 collateral to obtain a second LC from their own bank, which is used to pay
their own suppliers.
9. Sight Letter of Credit: Payment is made to the beneficiary immediately upon
presentation of the required documents
10. Usance Letter of Credit: Payment is made at a future date, which could
be 30, 60, 90 days or more after the documents are presented, giving the buyer
time to pay.
11. Red Clause Letter of Credit: Allows the beneficiary to receive an
advance payment before shipping the goods. The advance is deducted from
the final payment due.
12. Green Clause Letter of Credit: Similar to a Red Clause LC but also
covers expenses related to warehousing and other pre-shipment costs.

These different types of documentary credits cater to various needs in international

trade, offering flexibility and protection tailored to the specific circumstances of the
transaction.

Characteristics Of Documentary Credit:

Documentary credits, or letters of credit (LCs), are crucial instruments in
international trade, providing a secure mechanism for payment and risk mitigation.
Here are the key characteristics of documentary credits:

1. Conditional Payment: Payment under a documentary credit is made only

when the seller presents the required documents that conform to the terms and
conditions stipulated in the LC. The documents usually include a commercial
invoice, bill of lading, and other specified paperwork.
2. Independent Obligation: The LC is a separate and independent contract from
the underlying trade transaction. The issuing bank's obligation to pay is based
solely on the documents presented, not on the actual performance of the
contract between the buyer and seller.
3. Documentary Basis: Payment is contingent on the presentation of documents,
not on the physical goods. The accuracy and authenticity of these documents
are critical.
4. Transferability: Some LCs can be transferred to another party, usually the
seller’s supplier or intermediary. This is known as a transferable LC, allowing
the original beneficiary to pass on part or all of the credit to a secondary
beneficiary.
 5. Irrevocability: An irrevocable LC cannot be changed or canceled without the
consent of all parties involved, including the beneficiary. This offers a higher
level of security and certainty to the parties.
6. Confirmability: A confirmed LC includes a commitment by a second bank
(usually in the seller’s country) to honor the LC if the issuing bank fails to do
so. This adds an extra layer of security for the seller.
7. Expiry Date: LCs have an expiry date, which is the deadline by which the
required documents must be presented for payment or acceptance. If the
documents are not presented by this date, the LC becomes void.
8. Payment Terms: LCs specify payment terms, such as sight (immediate
payment upon presentation of documents) or usance (payment at a future date,
usually 30, 60, 90 days, etc.).
9. Compliance with Terms: The documents presented must strictly comply
with the terms and conditions set out in the LC. Any discrepancies can lead to
rejection of the documents and non-payment.
10. Fees and Costs: The buyer usually bears the cost of issuing the LC,
while the seller may incur additional costs for document handling, bank
charges, and possibly for confirming the LC.
11. Risk Mitigation: LCs reduce the risk of non-payment for the seller and
non-performance for the buyer, as the payment is secured by the bank and
dependent on document compliance.
12. Legal Framework: LCs are governed by international rules and
standards, such as the Uniform Customs and Practice for Documentary
Credits (UCP 600) established by the International Chamber of Commerce
(ICC), which provide a consistent and widely accepted framework.

These characteristics make documentary credits a valuable tool in international

trade, providing security and clarity in transactions where parties are often
geographically and culturally distant.

Permissibility of Documentary Credit:

Permissibility of documentary credit in Islamic finance involves ensuring that
such financial instruments comply with Shariah (Islamic law) principles.
Documentary credit, or letters of credit, can be deemed permissible if they adhere to
several key Shariah requirements:

1. Absence of Riba (Interest): The documentary credit must not involve any
interest. Riba, or usury, is strictly prohibited in Islam. Therefore, the financial
 terms of the credit must be free from any form of interest, ensuring that the
arrangement does not lead to interest-bearing transactions.
2. Clarity and Avoidance of Gharar (Uncertainty): The terms and conditions
of the documentary credit must be clear and precise. Shariah requires that all
aspects of the credit arrangement, including the documentation, payment
terms, and conditions for drawing, be well-defined to prevent excessive
uncertainty or ambiguity. This ensures fairness and transparency in the
transaction.
3. No Involvement in Maysir (Gambling): The documentary credit should not
involve any speculative elements or gambling. The credit arrangement must
be based on tangible, lawful transactions rather than speculative risks. This
aligns with the principle of avoiding gambling or undue risk.
4. Legitimate and Ethical Use: The credit must be used for lawful (halal)
purposes, supporting legitimate trade, investment, or other activities that
conform to Islamic ethical standards. The purpose of the credit should not
involve activities considered haram (forbidden) in Islam.
5. Transparency and Fairness: The credit arrangement should be transparent,
with all terms clearly documented and mutually agreed upon by all parties
involved. This ensures that the transaction is conducted fairly, with no
exploitation or injustice.
6. Avoidance of Harm: The documentary credit must not result in harm or
injustice to any party. Shariah emphasizes ethical conduct and equity, so the
credit arrangement should be structured to prevent any form of harm or unfair
treatment.

In summary, documentary credit is permissible under Shariah if it is structured to

avoid interest, excessive uncertainty, and gambling, and if it is used for lawful
purposes in a transparent and fair manner. Compliance with these principles ensures
that the credit arrangement aligns with Islamic finance ethics and legal standards.

Commissions and Expenses in Documentary Credit:

1. Types of Commissions and Expenses
o Issuing Bank's Commission: The bank that issues the letter of credit
typically charges a fee for its services. This fee is often a percentage of
the credit amount or a flat fee.
o Confirming Bank's Commission: If a letter of credit is confirmed by
another bank, this confirming bank will also charge a fee for providing
its guarantee.
 o Advising Bank's Fee: The bank that advises the letter of credit to the
beneficiary may charge a fee for this service.
o Document Handling Fees: Fees related to the examination, verification,
and processing of documents presented under the credit.
o Amendment Fees: Charges for making changes or amendments to the
letter of credit terms.
o Discrepancy Fees: Fees incurred if there are discrepancies or errors in
the documents presented, which need to be rectified.

2. Shariah Compliance Considerations

o Avoidance of Riba (Interest): All fees and commissions must be fixed
and agreed upon in advance. They should not be contingent upon the
outcome of the transaction or any form of interest-based calculation.
o Transparency and Agreement: All commissions and expenses should be
clearly defined in the letter of credit agreement. Both the buyer and
seller should be aware of and agree to these fees to ensure
transparency and avoid disputes.
o Fairness and Justification: Fees should be reasonable and justifiable for
the services rendered. Excessive or unjustified fees that could be
considered exploitative are not permissible.
o No Speculative Elements: The structure of fees and commissions
should not involve speculative elements or gambling. They should be
based on actual services provided and agreed terms.

3. Common Practices
o Pre-agreement on Fees: Fees and commissions are typically agreed
upon at the time of issuing the letter of credit. This agreement ensures
that both parties know the costs involved from the outset.
o Allocation of Costs: The allocation of costs between the buyer and
seller can be specified in the letter of credit. Commonly, the issuing
bank's fees are borne by the buyer, while the beneficiary may bear the
costs associated with confirming or advising banks.
o Documentation: All fees and expenses are documented and included in
the overall transaction costs. Proper documentation helps in
maintaining transparency and ensuring that all parties adhere to the
agreed terms.
 4. Practical Considerations
o Bank Policies: Different banks may have varying policies on fees and
commissions. It’s essential to review and understand these policies
before entering into a documentary credit arrangement.
o Negotiation: In some cases, the terms related to fees and commissions
can be negotiated between the parties involved. This negotiation
should be conducted transparently and documented in the letter of
credit.

In summary, commissions and expenses in a documentary credit are charges related

to the issuance, confirmation, and handling of the credit. They must comply with
Shariah principles by avoiding interest, ensuring transparency, fairness, and
justification, and avoiding speculative elements. Clear agreements and proper
documentation are crucial to managing these fees effectively in accordance with
both conventional practices and Islamic finance principles.

Murabahah Transactions in Documentary Credit:

1. Concept of Murabahah

 Definition: Murabahah involves a sale where the seller discloses the cost
price of the asset and adds a profit margin. The buyer pays the agreed-upon
selling price, which includes both the cost and the profit margin, either
immediately or on a deferred basis.
 Shariah Compliance: The transaction must be free from interest (riba) and
speculative elements (gharar). The terms of the sale, including the profit
margin, should be transparent and agreed upon in advance.

2. Application in Documentary Credit

Documentary credit (letter of credit) can be used to facilitate Murabahah

transactions by ensuring secure payment and adherence to Shariah principles. Here's
how it typically works:

1. Issuance of Documentary Credit:

o The buyer (importer) requests the issuing bank to open a letter of credit
in favor of the seller (exporter).
 o The letter of credit outlines the terms of the transaction, including the
Murabahah structure. It specifies the payment terms, the documents
required, and the conditions for payment.

2. Purchase and Sale Agreement:

o Bank’s Role: The bank, acting as the intermediary, purchases the asset
from the supplier or seller. The bank agrees to the Murabahah terms,
including the cost price and profit margin.
o Agreement with Buyer: The bank enters into a Murabahah agreement
with the buyer, specifying the cost price of the asset and the profit
margin to be paid by the buyer.

3. Documentary Credit Execution:

o Shipment and Documents: The supplier ships the goods to the buyer.
The bank receives the necessary shipping and transaction documents
(e.g., bill of lading, invoice) and verifies that they meet the terms of the
letter of credit.
o Presentation of Documents: The bank presents these documents to the
issuing bank or the buyer under the terms of the letter of credit.

4. Payment:
o Payment to Supplier: Upon receipt of the required documents, the
issuing bank makes payment to the supplier (or the bank if it’s a
confirming bank) as per the letter of credit terms.
o Repayment by Buyer: The buyer repays the bank according to the
Murabahah agreement, which includes the cost price plus the agreed
profit margin. This repayment can be made on a deferred basis if
agreed upon.

3. Shariah Compliance in Murabahah Documentary Credit

 Transparency: The cost and profit margin should be clearly stated in the
Murabahah agreement and the documentary credit. Transparency ensures
that the transaction is free from ambiguity and meets Shariah requirements.
 Avoidance of Riba: The transaction should not involve interest. The profit
margin is agreed upon in advance and is not linked to interest rates or
contingent on the outcome of the transaction.
  Avoidance of Gharar: The terms of the sale, including the cost and profit
margin, must be clearly defined. There should be no excessive uncertainty or
ambiguity in the transaction.
 Legitimate Purpose: The asset being purchased and sold must be for a lawful
purpose and should not involve any haram (forbidden) activities.

4. Benefits of Using Murabahah in Documentary Credit

 Shariah Compliance: Ensures that the transaction adheres to Islamic finance

principles, avoiding interest and speculative risks.
 Security: Provides a secure mechanism for financing and payment through
the use of documentary credit.
 Transparency: Facilitates clear and transparent transactions with defined
costs and profit margins.

In summary, Murabahah transactions in the context of documentary credit

involve the bank purchasing an asset and selling it to the buyer at a pre-agreed
profit margin. The documentary credit facilitates the transaction by ensuring secure
payment and compliance with Shariah principles. This structure allows for the
financing of trade while adhering to Islamic financial norms.