In international trade and finance, risk mitigation is a critical concern for both buyers and sellers. Two widely used financial instruments that help manage this risk are the Letter of Credit (LC) and the Bank Guarantee (BG). While both serve to provide financial security and build trust between parties, they operate in fundamentally different ways. An LC is primarily used to ensure payment in trade transactions, whereas a BG serves as a promise of compensation if one party fails to meet their obligations. Understanding the differences between these two instruments is essential for businesses engaged in global commerce to choose the right tool for their specific needs.
The Differences Between LC and Bank Guarantee (BG)
| Feature | Letter of Credit (LC) | Bank Guarantee (BG) |
| Purpose | Ensuring the payment to the seller upon fulfilling contract terms & conditions. | Acts as a financial safety net if the buyer fails to fulfill the agreement. |
| Risk Coverage | Primarily protects the seller (exporter) from risk. | Primarily protects the buyer (importer) or beneficiary from risk. |
| Nature | It is a conditional payment instrument where a bank guarantees payment if conditions are fulfilled. | It is a secondary obligation that the bank pays only if the client defaults. |
| Common Usage | Used in international & global business to ensure sellers that they get paid. | Used in domestic and international transactions for performance and the financial guarantees. |
| Initiated By | Issued by the Buyer (importer) | Seller (contractor) or buyer (client) |
| Payment Timing | Payment is made when the terms & conditions in LC are fulfilled. | Payment is made only in case of delay of default. |
| Risk for Bank | It is a higher risk since the bank promises to pay upon the document compliance. | It is a lower risk as the bank pays only if the client defaults or delay. |
When Can We Use?
- LC: If we want assurance that the seller gets paid when the goods or services are delivered as per the agreement.
- BG: If we want a guarantee that payment will be made only if conditions are not properly fulfilled.
