What is Trade Finance?

 Trade Finance

In international trade, where transactions span borders and continents, buyers and sellers must ensure secure and efficient payment methods. One such financial instrument that plays a pivotal role in facilitating international trade is the Letter of Credit (LC).  

Learn about frequently asked questions and answers concerning Letters ofCredit to support exporters and importers engaged in global commerce. Read more to learn about Letter of Credit Interview Questions! 

Table of Contents 

1) Frequently asked Interview Questions on Letter of Credit 

     a) What is a Letter of Credit? 

     b)  What are the types of Letters of Credit 

     c) Are the LC and bank guarantee the same? 

     d) How does a Letter of Credit work? 

     e) Who are the parties involved in Letter of Credit 

     f) What are the benefits of a Letter of Credit? 

     g) Which types of risks are there in Letters of Credit? 

     h) What are the bank's charges for Letters of Credit? 

     i) How long does it take to get a Letter of Credit? 

     j) What documents are required to open a Letter of Credit? 

2) Conclusion 

Frequently asked Interview Questions on Letter of Credit 

The following are the frequently asked Letter of Credit Interview Questions: 

1) What is a Letter of Credit? 

A Letter of Credit (LC) is a financial instrument widely used in international trade. It involves a contractual agreement between a buyer (applicant) and a seller (beneficiary) facilitated by a bank. The issuing bank issues the LC at the buyer's request, undertaking the obligation to pay the beneficiary a specified amount, provided the beneficiary fulfils the conditions outlined in the LC. This arrangement guarantees the seller that they will receive payment for shipped goods or rendered services as long as they comply with the terms and conditions stipulated in the LC. 

 2) What are the types of Letters of Credit? 

Letters of Credit (LC) come in various types, each designed to meet specific needs in international trade. A Commercial LC serves as a cornerstone in trade transactions by guaranteeing payment to the seller upon presenting compliant documents. Acting as a safeguard, the Standby LC functions as a backup payment method, ensuring that the seller receives payment should the buyer fail to fulfil its obligations. On the flexibility spectrum, the Revocable LC can be amended or cancelled unilaterally by the issuing bank without prior notice to the beneficiary, providing adaptability.  

The Irrevocable LC, in stark contrast, necessitates unanimous agreement for any amendments or cancellations, thus offering heightened security to the beneficiary. For added assurance, a Confirmed LC involves a confirming bank, a second financial institution, endorsing the LC, providing an extra layer of security. Lastly, the Transferable LC empowers the beneficiary to transfer all or part of the credit to another party, facilitating intricate and dynamic trade arrangements. Each type caters to specific trade scenarios, offering a range of features to accommodate diverse needs in the global marketplace. 

3) Are the LC and bank guarantee the same? 

Letters of Credit (LC) and bank guarantees are distinct financial instruments, each serving a unique purpose in international trade. Although both involve a commitment from a bank, their functions differ significantly. An LC acts as a secure payment method, guaranteeing that the seller will be paid upon fulfilling the specified trade terms outlined in the LC. It is a mechanism to secure payment for goods or services in a trade transaction.  

A bank guarantee is a commitment by the bank to pay a specified amount if the applicant (usually the buyer) fails to meet its contractual or financial obligations. Unlike an LC, a bank guarantee serves a broader purpose by ensuring performance in various scenarios beyond the simple exchange of goods, making the crucial distinction between the two lies in their primary functions and the scope of their applications in international business. 

Unlock the intricacies of Letters of Credit with our The Letters Of Credit Training Course for enhanced proficiency in accounting and finance! 

4) How does a Letter of Credit work? 

A Letter of Credit operates as a risk-mitigation tool in international trade. Once the buyer and seller agree on the terms of the sale, the buyer approaches their bank to issue an LC. The issuing bank sends the LC to the advising bank (usually located near the seller), informing the seller of the credit. The seller ships the goods and presents the documents to the advising bank. Upon verifying compliance, the issuing bank makes payment to the seller. This process ensures that payment is only made when the seller fulfils the agreed-upon conditions, reducing the risks for both parties. 

5) Who are the parties involved in a Letter of Credit? 

Various parties play distinct roles in the process of a Letter of Credit (LC). The applicant, usually the buyer, initiates the LC by submitting a request to their bank for issuance. This request outlines the terms and conditions under which payment should be made to the seller. Conversely, the beneficiary or the seller will receive compensation from the issuing bank upon fulfilling the conditions specified in the LC. The issuing bank takes a pivotal role in the transaction by issuing the LC, effectively committing to paying the beneficiary once they provide the necessary and compliant documents. The advising bank, often situated near the beneficiary, serves as an intermediary by informing the beneficiary about the LC. 

6) What are the benefits of a Letter of Credit? 

The following are the benefits of a Letter of Credit: 

1) Risk mitigation: Assures buyer and seller by ensuring payment is contingent on compliance with specified terms. 

2) Facilitation of international trade: Simplifies cross-border transactions by establishing a standard payment method. 

3) Assurance of payment: Sellers gain confidence that they will receive payment, while buyers ensure that payment is made only upon fulfilment of conditions. 

4) Compliance with contractual obligations: Ensures that the terms agreed upon in the sales contract are met before payment. 

7) Which types of risks are there in Letters of Credit? 

The following are the types of risks present in Letters of Credit:

1) Non-compliance risk: The risk that the beneficiary fails to meet the terms and conditions outlined in the LC. 

2) Fraud risk: Possibility of fraudulent activities, such as forged documents or misrepresentation. 

3) Political and economic risks: Fluctuations in economic conditions or changes in government policies impact the transaction. 

4) Documentary discrepancies: Risks arising from discrepancies between presented documents and the requirements of the LC. 

8) What are the bank's charges for Letters of Credit? 

Banks charge various fees related to issuing and managing Letters of Credit. These fees may include: 

1) Issuance fee: Charged for preparing and administering the LC. 

2) Confirmation fee: If applicable, for the confirming bank adding its confirmation to the LC. 

3) Advising fee: Covers the cost of communicating the LC to the beneficiary. 

4) Amendment fee: Charged for any changes or amendments made to the LC. 

9) How long does it take to get a Letter of Credit? 

The time to obtain an LC depends on factors such as the transaction's complexity, the involved parties' responsiveness, and the issuing bank's processes. Typically, it can range from a few days to several weeks. The procedure involves the buyer submitting an application, the bank reviewing and approving it, and finally issuing the LC. 

10) What documents are required to open a Letter of Credit? 

Standard documents required for opening an LC include:

1) Commercial invoice: Details of the goods or services being traded. 

2) Transport documents: Bill of lading, airway bill, or other documents proving shipment. 

3) Insurance documents: Proof of insurance coverage for the transported goods. 

4) Letter of Credit application: A formal request from the buyer to the bank to issue the LC. 

These documents help ensure that the LC accurately reflects the terms of the trade transaction. 

11) What are the features of Letters of Credit? 

A Letter of Credit (LC) possesses key features that enhance its efficacy in international trade. It ensures clarity through specific payment conditions, provides security with irrevocable terms, operates independently of the sales contract for added assurance, and allows transferability, facilitating complex trade arrangements. These features collectively contribute to the reliability and adaptability of LCs in global commerce, fostering trust and efficiency between parties. 

12) Is a Letter of Credit a loan? 

No, a Letter of Credit is not a loan. It is a payment instrument that ensures the seller receives payment upon compliance with the specified terms. Unlike a loan, where money is directly lent, an LC is a contingent obligation by the issuing bank to pay a specific amount to the beneficiary based on the presentation of compliant documents. 

13) Who issues a Letter of Credit? 

At the buyer's request (applicant), the issuing bank issues a Letter of Credit. The buyer initiates the process by applying to their bank, which then ensures payment to the seller upon satisfactory compliance with the specified terms. 

14) What are LC terms of payment? 

LC terms of payment specify when and how the seller will receive payment. Common terms include: 

1) Sight payment: Payment is made upon presentation of compliant documents. 

2) Usance payment: Payment is deferred for a specified period, often after a set number of days from the presentation of documents. 

These terms are agreed upon during the negotiation and drafting of the LC. 

15)  Who pays for a Letter of Credit? 

The costs associated with a Letter of Credit are typically borne by the buyer (applicant). However, the distribution of fees can be negotiated between the buyer and the seller. It is common for the buyer to cover the issuance fee, while the beneficiary may agree to cover other charges, such as confirmation or amendment fees. 

16) What is the cost of a Letter of Credit? 

The cost of an LC includes various fees, such as: 

1) Issuance fee: Covers the cost of preparing and issuing the LC. 

2) Advising fee: Covers the cost of communicating the LC to the beneficiary. 

3) Amendment fee: Charged for any changes or amendments made to the LC. 

The total cost depends on the bank's services and the transaction's complexity. 

17) What is the LC limit? 

The LC limit is the maximum amount the issuing bank is willing to issue Letters of Credit to a specific customer. It represents the buyer's creditworthiness and the issuing bank's assessment of the buyer's ability to meet payment obligations. The LC limit is determined based on various factors, including the buyer's financial standing and transaction history. 

18) Is the issuing bank allowed to make payment in a currency other than the currency agreed in the Letter of Credit? 

The issuing bank must make payment in the currency specified in the Letter of Credit unless otherwise agreed upon by the parties involved. The agreed-upon currency is a crucial aspect of the LC terms and is typically determined during the negotiation and drafting of the LC. Any deviation from the agreed currency requires mutual consent. 

19) How many times can a Letter of Credit be amended? 

The number of amendments to an LC is typically limited, and the terms for amendments are outlined in the original LC. Amendments may be necessary to accommodate changes in the transaction, such as an extension of the expiry date or a modification of the shipping destination. Excessive amendments can indicate a lack of clarity in the initial instructions or may lead to additional fees. 

20) What is deferred payment and how does it differ from a usance Letter of Credit? 

Deferred payment involves a credit period during which the buyer can delay payment for a specified period after the goods are delivered. This provides flexibility in managing cash flow. 

Usance Letter of Credit specifies a credit period granted by the issuing bank, indicating a future date when payment is due. It is a time draft, allowing the buyer additional time to settle the payment. Both mechanisms offer a form of credit to the buyer, but the key difference lies in how the credit period is structured. 

21) Can a bank guarantee be issued for services and goods such as commodities? 

A bank guarantee can be issued for various purposes, including services and goods such as commodities. A bank guarantee is a commitment by the bank to fulfil a financial obligation if the applicant fails to do so. It assures the beneficiary that they will receive payment or compensation in the event of non-performance or default by the applicant. Bank guarantees are versatile instruments used in various industries and types of transactions. 

22) What is Direct Benefit Transfer? 

Direct Benefit Transfer (DBT) is a mechanism governments use to transfer subsidies and welfare payments directly to the bank accounts of the intended beneficiaries. This approach aims to reduce leakages and ensure more efficient and transparent delivery of benefits. DBT enhances the effectiveness of social welfare programs and subsidy disbursements by eliminating intermediaries and directly crediting funds to beneficiaries. 

23) Why is a Letter of Credit known as a non-fund-based advance? 

Letters of Credit are categorised as non-fund-based advances because they do not involve directly lending money. Instead, they represent a contingent liability for the issuing bank. The bank commits to making a payment on behalf of the buyer, but actual funds are only disbursed when the beneficiary fulfils the specified conditions and presents compliant documents. The issuing bank's obligation is contingent upon the occurrence of certain events, making it a non-fund-based form of financial arrangement. 

24) What is the difference between TT and LC? 

Telegraphic Transfer is a method of transferring funds directly between banks. It involves the electronic transmission of payment instructions and is commonly used for quick and secure international money transfers. TT is a straightforward financial transaction without the additional layers of security and assurance an LC provides. 

A letter of Credit is a financial instrument that ensures payment to a seller based on compliance with specified terms in a trade transaction. While both involve banks, an LC adds a layer of security by guaranteeing payment upon presenting compliant documents. It is specifically used in international trade to mitigate buyer and seller risks. 

25) Why is a Letter of Credit a contingent liability? 

A Letter of Credit is considered contingent liability because the issuing bank's obligation to make payment is contingent upon the seller fulfilling the terms and conditions specified in the LC. Until these conditions are met, the liability remains contingent, indicating a potential financial obligation that becomes certain only when the beneficiary complies with the requirements. The issuing bank assumes a conditional responsibility, and the contingent nature of the liability distinguishes it from a direct, immediate financial obligation. 

Supercharge your financial expertise with our Accounting Masterclass for a confident stride in your financial journey. Sign up now! 

Conclusion 

A Letter of Credit serves as a sophisticated trade finance tool designed to safeguard importers and exporters against potential payment failures and various risks associated with cross-border trade, including currency fluctuations and political instability. It is, therefore, important to gain a comprehensive understanding of the Letter of Credit before incorporating them into international trade transactions. We hope you are now well equipped to face your next interview with our Letter of Credit Interview Questions and answers! 

Enhance your financial acumen with our Accounting and Finance Training Courses for a brighter career ahead!