Letter of Credit vs Bank Guarantee
An LC is meant to be drawn; a guarantee is meant to sit unused. Everything else follows from that.
A letter of credit and a bank guarantee are both written bank undertakings to pay a third party, both independent of the underlying contract, and both non-fund based facilities on the bank's books until they are called. The difference is in what each expects to happen.
A documentary LC is meant to be drawn: it is how the seller gets paid when the deal goes right. A guarantee is meant to sit unused: it pays only when the applicant has failed to perform. Almost every exam question on this topic is a version of that one idea.
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LC vs Bank Guarantee: Side by Side
Purpose
Documentary letter of credit
Payment mechanism for a sale of goods or services
Bank (demand) guarantee
Security against non-performance or default
Expected outcome
Documentary letter of credit
Drawn in the normal course
Bank (demand) guarantee
Not drawn if the applicant performs
Who triggers payment
Documentary letter of credit
Beneficiary, by presenting shipping and commercial documents
Bank (demand) guarantee
Beneficiary, by a demand stating the applicant is in breach
Documents
Documentary letter of credit
Invoice, transport document, insurance and others the credit lists
Bank (demand) guarantee
Usually only the demand and a supporting statement, plus anything the guarantee requires
Examination
Documentary letter of credit
Strict compliance with the credit, UCP 600 and ISBP
Bank (demand) guarantee
Compliance with the guarantee terms and URDG 758, much simpler on paper
ICC rules
Documentary letter of credit
UCP 600 (with eUCP for electronic presentation)
Bank (demand) guarantee
URDG 758 for demand guarantees; ISP98 or UCP 600 for standby credits
Typical forms
Documentary letter of credit
Sight, usance, revolving, transferable, back-to-back
Bank (demand) guarantee
Bid bond, advance payment, performance, retention money, financial guarantees
Bank's exposure
Documentary letter of credit
Contingent until documents are presented, then a payment obligation
Bank (demand) guarantee
Contingent; becomes funded only if invoked
| Point | Documentary letter of credit | Bank (demand) guarantee |
|---|---|---|
| Purpose | Payment mechanism for a sale of goods or services | Security against non-performance or default |
| Expected outcome | Drawn in the normal course | Not drawn if the applicant performs |
| Who triggers payment | Beneficiary, by presenting shipping and commercial documents | Beneficiary, by a demand stating the applicant is in breach |
| Documents | Invoice, transport document, insurance and others the credit lists | Usually only the demand and a supporting statement, plus anything the guarantee requires |
| Examination | Strict compliance with the credit, UCP 600 and ISBP | Compliance with the guarantee terms and URDG 758, much simpler on paper |
| ICC rules | UCP 600 (with eUCP for electronic presentation) | URDG 758 for demand guarantees; ISP98 or UCP 600 for standby credits |
| Typical forms | Sight, usance, revolving, transferable, back-to-back | Bid bond, advance payment, performance, retention money, financial guarantees |
| Bank's exposure | Contingent until documents are presented, then a payment obligation | Contingent; becomes funded only if invoked |
What They Have in Common
Both are independent undertakings. Under UCP 600, banks deal with documents and not with the goods, services or performance the documents relate to. Under URDG 758, the guarantee is independent of the underlying relationship between applicant and beneficiary, and of the application itself. In both cases the bank cannot refuse to pay because the buyer says the goods were poor or the contractor says the work was fine.
Both apply ICC rules only when the instrument says so. A guarantee is subject to URDG 758 because its text states it, not because the bank or the trade usually uses those rules.
Where the Standby LC Fits
- Standby letter of credit
- Legally a letter of credit, functionally a guarantee. It pays on the beneficiary's statement that the applicant defaulted. Common where local law or practice prefers the LC form.
- ISP98
- The ICC rules written specifically for standbys. A standby may instead be issued under UCP 600, which applies to standbys to the extent its articles can.
- Counter-guarantee
- A guarantee given by one bank to another to procure the issue of a local guarantee in the beneficiary's country. Common in export contracts where the buyer wants a guarantee from its own bank.
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Choosing Between Them in Practice
- check_circleAn Indian exporter wanting payment security from an overseas buyer asks for an LC.
- check_circleThe overseas buyer, paying an advance or awarding a contract, asks the exporter for a guarantee: advance payment or performance.
- check_circleIn the same contract both can exist: the buyer opens an LC for the price, the exporter's bank issues a performance guarantee for the obligation.
- check_circleFor an AD branch, both draw on the customer's non-fund based limit and need sanction under the bank's credit policy. RBI's Credit Facilities Directions for commercial banks carry a separate chapter on non-fund based facilities.
Do Not Confuse With Collections
A documentary collection under URC 522 is neither. The bank only handles documents and gives no undertaking to pay. If a question describes a bank releasing documents against payment or acceptance with no promise of its own, the answer is collection, not LC.
How CCFE Tests This
Questions are definitional and scenario-based. The usual traps:
- check_circle"Primary vs secondary": the LC is a primary payment route; the guarantee is a secondary obligation in commercial terms, even though legally it is independent. Do not read "secondary" as "dependent on the contract".
- check_circleMatching rules to instruments: UCP 600 to LC, URDG 758 to demand guarantees, ISP98 to standbys, URC 522 to collections.
- check_circleAssuming guarantees need shipping documents. A demand guarantee typically needs only a demand and supporting statement.
- check_circleCalling a standby a guarantee in law. It is a credit in form and a guarantee in function.
FAQs
What is the main difference between a letter of credit and a bank guarantee?expand_more
An LC is a payment instrument meant to be drawn when the seller performs and presents documents. A bank guarantee is a security instrument meant to be drawn only when the applicant fails to perform.
Which ICC rules govern an LC and a bank guarantee?expand_more
Documentary LCs are usually issued subject to UCP 600. Demand guarantees are issued subject to URDG 758, in force since 1 July 2010. Standby LCs use ISP98 or UCP 600.
Is a standby letter of credit an LC or a guarantee?expand_more
In form it is a letter of credit; in function it works like a guarantee, paying on the beneficiary's statement of default.
Are LCs and bank guarantees fund based or non-fund based?expand_more
Both are non-fund based facilities when issued. They become funded exposure only when the bank pays and the applicant has not yet reimbursed it.
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