A standby letter of credit is a legal payment assurance given by a bank or a financial institution to the beneficiary against any default made by its applicant (buyer). In simple words, the issuing bank guarantees the fulfillment of the buyer’s contractual obligations in case of the buyer’s incapability and offers the security of payment to the seller by reimbursing the full or remaining amount.
Unlike other types of LCs (Letters of Credit), SBLCs are secondary payment instruments whereby the banks are only required to make the payment in the event if the buyer defaults. In the case of LCs, the banks make the payment first and then recover it from the applicant at a later date. It is one of the most used trade finance instruments in international trade transactions. The issuance of standby LCs will only take effect if the applicant defaults on its duties mentioned under the SBLC contract. To conclude, we can say that it is a legal document where a bank guarantees an on-time payment to the seller in case the buyer is at default.
This type of Standby LCs comes with an irrevocable undertaking made by the bank guaranteeing the buyer’s obligation to pay to the seller. To put it simply, the bank ensures that the suppliers in international trade deals will get the payment for the delivered goods even if the buyer defaults.
This type of SBLC is less used in global trade as compared to Financial SBLC. In Performance Standby LC, the bank guarantees an on-time completion of a project to the beneficiary as per the mentioned terms & conditions. In the event, if the service provider fails to deliver the predetermined service to the buyer within a stipulated period, the bank will reimburse the beneficiary. In simple words, it provides contractual security to the beneficiary on performance compliance from the service provider as agreed by T&C.
This type of Standby letter of credit is issued when an advance amount has been issued from the buyer to the seller as a down payment. In the event, if the seller defaults to provide goods or services on time, the buyer can claim the advance payment through this SBLC. It provides security to the buyer against the seller's failure to deliver the goods & services after receiving advance payment.
By issuing a Tender Bond or Bid Bond SBLC, the bank guarantees the applicant’s capability to execute the contract as per the T&C if the applicant is awarded a bid. In simple words, the bank provides a security to the contractor against the failure of the applicant to complete the project once the applicant has been awarded the bid or tender for the contract.
It is also known as a backstop or a protective standby where a bank in one country issues a Counter SBLC to the bank in another country requesting them to issue a new Standby to their domestic beneficiary. In simple words, it includes the issuance of a separate SBLC or another undertaking to the beneficiary who already has a Counter SBLC.
This type of SBLC is irrevocable and is issued to provide security in the event of the financial incapability of the applicant. In other words, it acts as payment security when an underlying payment obligation is due in connection with a Financial SBLC without regard to a default.
An Insurance SBL provides security to the beneficiary in the event if the applicant has promised insurance or reinsurance but fails to do it. In other words, the bank guarantees the buyer’s insurance or reinsurance obligation to the beneficiary.
In case if any of the parties-to-the-contract seeks a secondary obligation from the bank to cover any losses arising other than the primary SBLC contract between both buyers & sellers, a Commercial SBLC is issued. For example, if the buyer defaults in paying his financial obligations, then the seller can recover the payments using Commercial SBLCs. To put it simply, the bank provides security to the beneficiary regarding the fulfillment of the contractual obligations on behalf of the buyer.
These are some of the most commonly used types of Standby Letters of Credit as a trade finance instrument in global trade. There are many advantages of using SBLCs in global trade but the most prominent one is that it provides payment & performance security to both buyers & sellers involved in foreign trade transactions.