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.
Letters of Credit
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.