DISCOUNTING VS. NEGOTIATION UNDER LCs: WHAT’S THE DIFFERENCE?

QUESTION:

What is the difference between discounting and negotiation in the context of letters of credit? Could you clarify?

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ANSWER:

Hi,

Great question — it’s one that often comes up in trade finance.

Under UCP 600, the term officially used is “negotiation”, not “discounting.” According to Article 2 of UCP 600, negotiation refers to:

“The purchase by the nominated bank of drafts (drawn on a bank other than itself) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the day reimbursement is due.”

In simpler terms, negotiation happens when a nominated bank agrees to pay the exporter (beneficiary) before the importer’s bank is scheduled to reimburse it — in effect, purchasing the draft and/or documents early.

On the other hand, the term “discounting” is not defined in UCP 600, but it’s frequently used in practice. When people say “discounting” in the LC world, they’re often referring to the act of a bank (typically the nominated bank) advancing payment against a usance draft or deferred payment undertaking that it has itself accepted or incurred. In such cases, the nominated bank takes on the credit risk and funds the beneficiary before the maturity date, at a discount.

So, what’s the real difference?

• Negotiation involves purchasing drafts/documents under an LC, and typically involves a draft drawn on another bank.
• Discounting usually involves a bank funding an accepted usance obligation — often one that the bank itself has committed to — and applying a discount to reflect the time value of money until maturity.

That said, in real-world banking, the terms are often used interchangeably, especially among practitioners who understand the context.

Note: This explanation is specifically limited to the context of documentary credits (LCs) and may not apply to other forms of trade finance or commercial lending.

Kind regards,

Mr. Old Man