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What's the difference between a bank guarantee

and a letter of credit?


By Peter Cherewyk

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A:

A bank guarantee and a letter of credit are similar in many ways but they're two
different things. Letters of credit ensure that a transaction proceeds as planned, while
bank guarantees reduce the loss if the transaction doesn't go as planned.
A letter of credit is an obligation taken on by a bank to make a payment once certain criteria
are met. Once these terms are completed and confirmed, the bank will transfer the funds.
This ensures the payment will be made as long as the services are performed.
A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a
line of credit, the sum is only paid if the opposing party does not fulfill the stipulated
obligations under the contract. This can be used to essentially insure a buyer or seller from
loss or damage due to nonperformance by the other party in a contract.
For example a letter of credit could be used in the delivery of goods or the completion of a
service. The seller may request that the buyer obtain a letter of credit before the transaction
occurs. The buyer would purchase this letter of credit from a bank and forward it to the
seller's bank. This letter would substitute the bank's credit for that of its client, ensuring
correct and timely payment.
A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash
flow difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum
to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then
pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety
measure for the opposing party in the transaction.
These financial instruments are often used in trade financing when suppliers, or vendors, are
purchasing and selling goods to and from overseas customers with whom they don't have
established business relationships. The instruments are designed to reduce the risk taken by
each party.

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