Letters of Credit and Bank Guarantees are the two most commonly used trade finance instruments in an international trade deal. Both are issued by a bank or legal financial institution to mitigate the payment risks between the parties as well as to safeguard the parties’ interests. Both demonstrate that the buyer/importer will pay the beneficiary/seller/exporter on time. In case, if the buyer is unable to do so, the issuing bank will step in and take the charge for the same. But they work slightly in different ways in different situations.
Also known as a documentary credit, or payment guarantee letter, an international letter of credit service is a legal document issued by the buyer’s bank or financial institution to the seller’s bank. It is a confirming document that assures that the payment will be made to the seller by the buyer once the terms & conditions mentioned in the LC agreement are fulfilled by both parties. But in case of the buyer defaulting, the issuing bank will compensate. Read our comprehensive guide on letter of credit.
A Bank guarantee is also a legal contract where the issuing bank is committed to paying the beneficiary on behalf of its applicant i.e. buyer as per the terms & conditions of the BG contract. But the issuing bank will only enter when the buyer defaults or fails to make the payment. In simple words, it protects against non-performance. Know the types of BG.
A key difference between an LC and BG is that the use of a global letter of credit service settles the payment between the parties till the trade deal is completed as per the T&C of the LC agreement while in a BG, the bank only steps up when there is a non-performance on the hands of the buyer.
A letter of credit ensures that the transaction is executed between the parties as it was planned, and takes full responsibility for an error-free transaction while in a bank guarantee, the issuing bank commits an on-time payment to the seller on behalf of the buyer in case the buyer fails to do so.
2. Area of Use -
Bank Guarantee services are most frequently used in real estate agreements and construction projects while LCs have a more vital role in international trade & transactions.
3. Risk -
An LC ensures that the seller receives the payment as per decided in the LC agreement while a BG works only to mitigate the losses in case the buyer denies his duties intentionally or unintentionally.
4. Number of Parties Involved -
A letter of credit includes mainly five or more parties such as the Buyer, Seller, Issuing Bank, Consulting Bank, Negotiating Bank, and Validating Bank while in a BG service, there are only three parties ie. buyers, sellers, and lenders.
5. Default -
A Letter of Credit becomes effective when the payment is due while a BG becomes effective when there is a default by the buyer.
It depends on the nature of trade deals taking place between the parties. On one hand, an LC protects both the importers & exporters while a bank guarantee only protects sellers from the risk of non-performance.
Consult with the finance experts at Axios Credit Bank Ltd. The experienced & well-informed team deeply reviews your trade transactions and provides you with a suitable trade finance service. We are easing the trade deals between global importers & exporters on an international level with the latest fintech trade solutions.