Letter of Guarantee

A particular kind of contract that a bank will issue on behalf of a client who has contracted to buy products from a supplier

Author: Andy Yan
Andy Yan
Andy Yan
Investment Banking | Corporate Development

Before deciding to pursue his MBA, Andy previously spent two years at Credit Suisse in Investment Banking, primarily working on M&A and IPO transactions. Prior to joining Credit Suisse, Andy was a Business Analyst Intern for Capital One and worked as an associate for Cambridge Realty Capital Companies.

Andy graduated from University of Chicago with a Bachelor of Arts in Economics and Statistics and is currently an MBA candidate at The University of Chicago Booth School of Business with a concentration in Analytical Finance.

Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:November 5, 2023

What Is a Letter of Guarantee?

A letter of guarantee (LoG) is a particular kind of contract that a bank will issue on behalf of a client who has contracted to buy products from a supplier. This assures the payment provider, even if the bank's client defaults.

Like applying for a loan, the customer must use it to receive a guarantee letter. For an annual fee, the bank will back the consumer with the letter if they feel comfortable with the risk.

A bank may also provide a LoG on a call writer's behalf, ensuring that the writer is the owner of the underlying asset and that the bank will deliver the underlying assets if the call is exercised. 

When the underlying asset of a call option is not kept in their brokerage account, call writers frequently utilize a letter of assurance.

  • The letter is a legal document that a bank issues on behalf of a client who has contracted to buy products from a supplier.
  • Letters of guarantee assure the provider that payment will still be made even if the bank's client defaults.
  • On behalf of a call writer, a bank may provide a guarantee letter stating that the writer is the owner of the underlying asset and that the bank will deliver the underlying assets if the call is exercised.
  • When one party in a transaction is unsure that the other party will be able to pay their financial obligation, letters of guarantee are frequently utilized. This is particularly common with purchases of expensive equipment or different property types.
  • In many different commercial contexts, such as contracting and construction, obtaining financing from a financial institution, or making declarations during the export and import processes, letters of guarantee are employed.

When one party to a transaction is unsure that the other side can fulfill their financial obligation, letters of guarantee are frequently employed. This is especially typical when expensive machinery or other property is purchased. 

It might not, however, cover the entire loan. For instance, a bond issue might guarantee repayment of the principal or the interest but not both.

The bank will discuss with their client how much they will pay. For this service, banks charge an annual fee that is often based on the potential amount they would repay their client in the event of default.

There are many different business contexts where letters of guarantee are appropriate. Contracting and building, financing from a financial institution, or making statements throughout the export and import procedures are a few examples.

What Situations Call for a Letter of Guarantee?

A broker frequently takes a LoG from call writers with short options in place of storing cash or securities because many institutional clients keep their investment accounts at custodian banks rather than broker-dealers. 

The guarantee letter must be submitted in a format acceptable to the exchange and, possibly, the Options Clearing Corporation. If the call writer's account is assigned, the issuing bank consents to provide the broker with the underlying securities.

1. New vendor

Since there is a lot of uncertainty between the two parties and the new supplier does not have a history of dealing with the customer, a client usually sends this letter to a new supplier.

When a customer wants to buy expensive machinery and equipment, but the supplier does not want to offer trade credit, the practice is most prevalent.

2. Start-up company

Early-stage businesses might not have enough cash to pay for purchases of goods right away, so they might request a guarantee letter from the bank. However, the supplier could also not assess the company's ability to pay as they do not have a credit history.

3. Dealing with a supplier outside the usual trading area

Suppliers may request LoG from companies that conduct business internationally to demonstrate their commitment to paying for the products. 

This is due to the possibility of increased expenses when supplying goods outside of the nation, and suppliers need a bank's assurance that they will be paid if customers fail to make payments.

Process for Issuing Letter of Guarantee

When a supplier requests one or is unsure of the firm's ability to pay for the items delivered, the company may ask the bank for a guarantee letter. When writing the guarantee letter, a bank follows the steps below.

1. Examining and issuing

A bank must decide whether a customer is eligible for a letter of guarantee when it receives an application for one. 

It does this by carefully examining the underlying transaction, the history of commerce, and other pertinent facts. Then, the bank may ask the consumer if more information or proof is required.

2. Fees 

Fees are calculated by the guidelines and rates outlined in the issuing bank's rules.

3. Letter of guarantee amendment

The client is guaranteed, or the beneficiary may request amendments to the guarantee letter before the bank issues it. For example, the underlying asset, the validity period, etc., could all be the subject of the changes.

4. Compensation against the letter of guarantee

The bank must inform the client of the request when the supplier has delivered the items to the customer and has requested payment from the guaranteeing bank within the validity period. 

The bank will then review the claim documentation and ensure that it complies with the letter of guarantee's claim clauses. Finally, if the bank accepts the claim, it pays the provider a sum corresponding to the quantity of work completed.

5. Post-guarantee management

The bank adjusts the customer's records to reflect the changes after making the payments to the supplier. The bank also keeps a copy of the guarantee letter and checks to ensure it accurately reflects the transactions. 

The guarantee is revoked, and the credit line is recovered from the customer once the bank certifies relief from the guarantee letter of guarantee liability; if there is a surplus, the customer is given a reimbursement.

Blockchain and letter of guarantee

A letter is a contract that a bank issues on behalf of one of its clients who has made a purchase agreement with a supplier. 

The LoG assures the provider of payment, even if the bank client is in default. However, the buyer must request it to get one.

Blockchain technology has the potential to be entirely digital, paperless, and transparent in the guarantee letter procedure.

Since the blockchain network is secured by permission members, including respectable financial institutions, this transparency aids in the elimination of fraud and counterfeiting.

Blockchain and digitalization are excellent options for highly paper-based financial instruments, particularly those that involve back-and-forth agreements between participants. One such tool is a bank guarantee, also referred to as a letter of guarantee.

Bank guarantees facilitate business transactions by fostering trust between two parties, such as a seller and a buyer or a landlord and a tenant. 

The bank honors the promises of reimbursement even if the buyer defaults or the tenant doesn't pay the rent. Moreover, if the other party fails to provide a product or high-quality service, the beneficiary is safeguarded by a letter of guarantee that also covers performance.

Although the idea of a bank guarantee is widely accepted in the sector, its actual implementation is not. 

Every bank has its collection of policies, forms, and guidelines. As a result, there may be multiple drafts and rounds of negotiation before an agreement is reached, and if changes are needed, the entire process must be repeated. Typically, it takes up to a month to issue a one-page contract.

This creates a highly secure network for document filing and retrieval, where each transaction is recorded in an immutable, auditable ledger — which is not owned by any central entity.

  • The benefits of an IBM Blockchain-based LoG solution

1. Decrease cycle time and expenses

A standardized, blockchain-based network can reduce this time from days or weeks to only one day from application to issue. As a result, the danger of conflicts is decreased, the processing time is shortened, and reporting and monitoring are improved when there is a "single source of truth."

2. Boost security and stop fraud

The letter is encrypted, executed by only authorized network participants, and kept as an immutable record on the blockchain. Anybody with permission can audit the document.

3. Improve productivity and visibility

Completely digital workflows make it simple for applicants, beneficiaries, and issuers to examine, administer, and report on their letters of guarantee. All essential operations are also accessible online through a user-friendly user interface.

The case for blockchain is further strengthened when you consider the danger of fraud connected with paper-based processes. 

Automating Letters of Assurance with Blockchain

You need a repeatable solution built on the Blockchain Platform that automates the process of looking for, approving, updating, issuing, and storing letters of assurance. 

Blockchain Services typically works in partnership with these parties for this solution to be tailored to the norms and procedures mutually agreed upon by a group of financial institutions and high-volume beneficiaries.

The answer includes:

  • A user-friendly web interface.
  • A digital procedure.
  • A framework for codifying standard terms and conditions. 

These agreements are encrypted using smart contracts on the blockchain, creating legally enforceable contracts and automating workflow phases to quicken the approval process. In addition, blockchain technology offers immutable data storage and encryption, which aids in preventing fraud. 

Transparency makes it possible for requestors, banks, and recipients who have permission to participate in issuing a letter of guarantee to monitor the progress of applications or read the final digital document.

Financial services based on blockchain are being developed in Thailand.

BCI (Thailand) Co., Ltd., formerly known as the Thailand Blockchain Community Initiative, was established to build a blockchain-based network that would enable electronic letters of guarantee (LG). 

Twenty-two banks and 15 businesses now utilize the technology to support payment obligations for business auctions and other domestic trading activities.

Thanks to the platform, a letter of assurance may be issued in less than a day, and some users claim to have saved 200 percent on transaction costs. In addition, the solution aims to reduce the risk of mistakes and fraud for all parties involved.

Thailand's large, medium, and small firms can efficiently utilize BCI's LG services. Customers can use several methods to access the BCI portal, including private on-premises, cloud, and cloud broker access.

The blockchain platform from BCI provides cutting-edge features, including multi-vendor and genuine hybrid cloud support, high availability across many regions, and disaster recovery.

We are building on the experience and assets, digitizing paper operations in the banking industry.

The system for electronic letters of guarantee is both repeatable and expandable. Moreover, it can swiftly duplicate the solution for other financial institutions and companies because they've already established it for existing clients. 

Terms and conditions, regulations, codified procedures, user interface templates, and APIs for interfacing with existing systems of record can all be tailored for your specific business ties and possible participants.

Also possible is platform expansion. Once your solution is in production, you and all the partners can use the platform to expand into new fields, automate other paper-based financial processes, and offer new services to clients. 

By utilizing an existing customizable solution and Blockchain Services' expertise, businesses may get from concept to operational pilot in as little as three months. 

By bringing additional people into the network, you can begin scaling up after putting what you've learned from the pilot to use.

The base of the solution is The Blockchain Platform, a for-profit variation of The Linux Foundation's open-source Hyperledger Fabric. The Blockchain Platform is cloud-agnostic. Thus it may operate in any cloud or on-premises. 

Each member of the blockchain network can store their data either on their own IT infrastructure or with a different cloud service provider. In addition, the platform can facilitate global business contacts because it conforms to GDPR.

Researched and authored by Ruxue Bai | LinkedIn

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