Why are Bank Guarantees and Standby Letters of Credit so Popular?

We are mainly approached to monetise Bank Guarantees and Standby Letters of Credit. But exactly what is a Bank Guarantee and a Standby Letter of Credit? They are both bank instruments used for different purposes as explained below.

Bank Guarantee – an Overview

A bank guarantee is a guarantee of payment that fall under two categories – A Financial Guarantee and a Performance Guarantee.

Financial Guarantee – The beneficiary is guaranteed payment if the applicant fails in their fiduciary duty.

Performance Guarantee – The beneficiary is guaranteed payment to cover a loss. This loss is incurred when the applicant fails to perform on a contract. For example, the late delivery of perishable goods or on a larger scale, the late delivery of a cruise ship.

The applicant is the counterparty to the beneficiary of the financial guarantee. The applicant instructs their bank to issue the bank guarantee. This bank becomes the issuing bank and is responsible for paying all claims.

Standby Letter of Credit – an Overview

The standby letter of credit is a means of payment. It underpins international and national trade contracts and is a payment of last resort. It is a contract between a seller and a buyer, protecting the seller if the buyer does not pay for goods received.

If the seller is unsure of payment they ask the buyer to open a standby letter of credit. The buyer instructs their bank to issue a standby letter of credit favouring the seller. If the buyer fails to pay, the seller can claim against the standby letter of credit. The seller instructs their bank to claim against the buyer’s bank and the buyers bank will claim a similar amount from the buyer.

Standby Letter of Credit, (SBLC) and a Documentary Letter of Credit, (DLC)

We are regularly asked the difference between these two instruments. They are both a means of payment. The difference is explained below,

Documentary Letter of Credit – guarantees payment on the performance of the seller.

Standby Letter of Credit – guarantees payment on the non-performance of the buyer.

Please note a standby letter of credit when monetised becomes a guarantee of payment.

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