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What is Bank Guarantee and Standby Letter of Credit?

Let's begin by understanding simply before going to the definition.
We have two entities, be it two people or two companies, who need to work with each other. They have some underlying relationship, it may be that one owes the other some money or it may be one is supposed to do some work for the other. But they don't trust each other fully and want a third party to guarantee that the money that is owed will be repaid or, if the work is not done properly then there will be a monetary compensation. But how can such an assurance be obtained? Using an instrument for this assurance, like a guarantee or a standby letter of credit. 

So, the one who needs to arrange this assurance is called the applicant, the third party who actually provides this assurance or guarantee is called the guarantor, which is usually a bank and the one who wants to enjoy this assurance or guarantee is called the beneficiary.

The basic process flow of a Guarantee/ SBLC

1. The applicant applies to the bank for the guarantee to be issued in favour of the beneficiary. 
2. Once the guarantor gives the guarantee, he cannot backtrack and withdraw it without the consent of the other parties. 
3. In the event that the applicant fails to fulfill his obligation as per the contract, be it repaying money or doing the work assigned...
4. ...the beneficiary will demand his compensation from the guarantor following the terms of the guarantee...
   
5. ...and the guarantor will keep his word and compensate the beneficiary. 

This is the basic way of working of guarantee or SBLC.

The formal definitions of Bank Guarantee and Standby Letter of Credit

A guarantee is an irrevocable undertaking issued by the guarantor to pay the beneficiary a sum of money up to the maximum amount of the guarantee, provided a complying demand is presented as per the terms of the guarantee. This kind of guarantee is called a demand guarantee. It must be in writing. It may be in paper form or electronic form. In paper form, it must be signed. In electronic form, the identity of the guarantor must be authenticated.

A standby letter of credit is an irrevocable undertaking issued by the issuer to pay the beneficiary a sum of money up to the maximum amount of the SBLC, provided a complying demand is presented as per the terms of the SBLC. Just like a demand guarantee, a SBLC should also be in writing, either in paper or electronically and the issuer’s identity must be authenticated. A SBLC, though issued in the form of a letter of credit, performs the function of a guarantee. 

As you can understand from the definitions that both these instruments are very similar to each other, but there are some differences which we will discuss in a later blog.

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