Letters of Credit and Bank Guarantees are some of the most commonly used mechanisms to mitigate risk of default and or non-performance in international trade transactions. However, while both can help to achieve similar goals, they work differently.
Letters of Credit
A letter of credit (LC) is a form of documentary credit issued by the buyer’s bank and sent to the seller’s bank. It is a formal document confirming an undertaking that payment will be made to the seller, on behalf of the buyer, once documentary proof that terms and conditions contained within the letter of credit, to which buyer and seller have agreed, are fulfilled.
Bank Guarantees
A bank guarantee is contract that makes it obligatory upon the issuing bank to pay a certain amount of money, on behalf of the applicant (the person on whose behalf the guarantee is issued), to the beneficiary, on a specified date or in accordance with some other condition(s), if the applicant fails to make the payment. It is effectively insurance against non-performance.
How They Are Different
A key difference between the two is that, if an LC is used (except Standby LCs), it will be the mechanism used to settle the payment, while if a bank guarantee is used, it is usually only used as a mechanism of settlement in the event of default or non-performance. Here are some other major differences:
| Letters of Credit | Bank Guarantees |
| An LC is riskier for the bank than the importer, as the bank must ensure all conditions are met, make the payment and then collect the payment form the importer. | A bank guarantee is riskier for the merchant than the bank as, if the merchant does not perform, the bank will honour the guarantee and the merchant will be forced to pay up. |
| 5 or more parties are usually involved in an LC; including the two merchants, their two banks and potentially other banks in between and other parties such as freight forwarders/subcontractors to the importer/exporter. | Usually, only 3 parties are involved in a bank guarantee; the applicant, the beneficiary and the bank that issues the guarantee. |
| An LC ensures that payment will be made provided the goods/services are supplied in accordance with the terms of the LC. | A bank guarantee works to mitigate a loss if the applicant does not perform as agreed. |
Which Should You Choose?
It all depends on your circumstances. An LC provides the best risk mitigation for both importers and exporters simultaneously, while a bank guarantee can help protect one party or the other from the risk of non-performance.
Speak with our team of trade finance specialists at Euro Exim Bank to better understand which instrument will be right for you. We are dedicated to assisting SMEs and businesses around the world through the adoption of the latest cutting-edge digital technology to create accessible and flexible trade finance solutions.