If you are a global trader, you might be aware of using different types of trade finance instruments. And letters of credit & bank guarantee are one of them. but only a few of you know how these instruments differ from each other. Since they both are frequently used in international trade transactions, and both assure sellers/exporters regarding paying on-time by worldwide importers/buyers. Then, how are they different? If you also want to know, keep reading. This blog contains a brief discussion about both of them as well as key areas of differences.
Let’s first start by understanding their meaning.
1. A letter of credit, also known as a payment guarantee letter or a documentary credit is a legal document issued by a bank or a financial institution where a letter of credit service provider guarantees an on-time and full-fledged payment to the exporters.
2. In the event, if the importer defaults or is unable to pay or perform the terms & conditions of the LC agreement, the whole or remaining amount will be reimbursed by the issuing bank.
3. In simple words, while issuing an LC, the issuing bank promises that the exporters will be paid on-time by the importers.
4. A payment guarantee letter is one of the most frequently used trade finance instruments that signifies a bank’s obligation to make the payment in case if the applicant fails or defaults.
5. When the terms & conditions of the LC agreement are fulfilled by the exporters, the bank will transfer the funds.
1. Revocable & Irrevocable LC
2. Confirmed & unconfirmed LC
3. Transferable & non-Transferable letter of credit
4. Red clause & green clause payment guarantee letter
5. Commercial documentary credit
6. Standby & back to back LC etc.
1. On the contrary, a bank guarantee or BG is also a legal promise made by the issuing bank to the sellers that they would be paid on-time but unlike LC, it comes into effect only in case if the opposing party i.e. buyer defaults or unable to fulfill the contractual obligations mentioned in the BG contract.
2. In other words, the issuing bank is only liable to pay the beneficiary in case if the applicant defaults in performing his obligations.
3. In the BG contracts, the banks act as a surety for reimbursing the debt if it is not paid by the applicants.
1. Financial Guarantee
2. Performance Guarantee
The below-mentioned points will also help you understand the key areas of differences between these two trade finance instruments. Let’s have a look:
1. Liability of Bank - In the case of an LC issued, the liability of the bank is primary while in the case of a bank guarantee service, it is secondary.
2. Risk Involved - The parties involved in an LC bear less risk than banks while in BGs, the risk is more for the parties compared to banks.
3. Parties Involved - LC comes with 5 or more parties while in the case of BGs, there are only three parties.
4. Default Extent - An LC service provider does not wait for the buyer’s default to release the funds in the name of the beneficiary. On the contrary, a BG agreement becomes effective only when the buyer is at the default.
5. Used-In - Letters of credits are most commonly used in international transactions for import-exports while a bank guarantee is used in government contracts.
A letter of credit is essentially used in international trade transactions but with time, it is being used in domestic trade also. It doesn’t matter whether it is a global market or a local one, the suppliers always look for payment assurance to secure their interest. On the other hand, a bank guarantee is used to execute various business transactions.