LCs and Guarantees

Trade Finance: Letters of Credit & Bank Guarantees 🏦

The Story of the Nervous Toy Buyer

Imagine you want to buy 1,000 teddy bears from a toy factory in another country. You’ve never met them. They’ve never met you.

You worry: “What if I send money and they never ship the toys?”

They worry: “What if we ship the toys and they never pay us?”

Enter the superhero: THE BANK! 🦸

Banks created special “promise notes” that protect BOTH of you. These are called Letters of Credit and Bank Guarantees.

Think of banks as the trusted referee in a game where two strangers need to play fair.

📜 Part 1: Letters of Credit (LC) Overview

What is a Letter of Credit?

A Letter of Credit is like a pinky promise from a bank.

The bank says: “I promise to pay the seller ONLY when they show proof they did their job correctly.”

graph TD
    A["🧒 Buyer wants toys"] --> B[🏦 Buyer's Bank]
    B --> C["📜 Issues LC - Promise to Pay"]
    C --> D["🏭 Seller sees LC"]
    D --> E["📦 Seller ships toys"]
    E --> F["📄 Seller shows shipping documents"]
    F --> G["💰 Bank pays seller"]

Simple Example:

• Mom says: “I’ll give you ice cream ONLY when you show me your finished homework.”
• The LC is like Mom’s promise. The homework is like shipping documents.

Why Do People Use LCs?

📋 Part 2: Types of Letters of Credit

There are different flavors of LCs, like different flavors of ice cream!

1. Revocable vs Irrevocable LC

Most LCs today are IRREVOCABLE because sellers want certainty.

2. Confirmed vs Unconfirmed LC

Unconfirmed LC: Only ONE bank promises to pay (buyer’s bank)

Confirmed LC: TWO banks promise to pay!

• Buyer’s bank + Seller’s local bank both guarantee payment
• Double safety net! 🎪

Example: If you’re selling to someone in a country with banking problems, you want YOUR local bank to ALSO promise payment. That’s confirmation!

3. Sight LC vs Usance (Time) LC

4. Transferable LC

The seller can transfer the LC to another person (like a supplier).

Example: You buy toys. The seller doesn’t make toys but knows someone who does. They transfer the LC to the actual toy maker.

5. Back-to-Back LC

Two separate LCs linked together.

• First LC: Buyer → Middleman
• Second LC: Middleman → Actual Supplier

Like a relay race where the baton (payment promise) passes from runner to runner! 🏃

6. Standby LC

This is a “backup” LC. Used only if something goes wrong.

Example: A contractor promises to build your house. The Standby LC says: “If the contractor fails, the bank will pay you damages.”

📄 Part 3: LC Documentation Requirements

Documents are the proof that makes the LC work. Without correct documents, NO PAYMENT!

The Big Five Documents

graph TD
    A["📄 LC Documents"] --> B["📜 Commercial Invoice"]
    A --> C["🚢 Bill of Lading"]
    A --> D["📋 Packing List"]
    A --> E["🔍 Certificate of Origin"]
    A --> F["📑 Insurance Certificate"]

The Golden Rule of LC Documents

EVERY WORD MUST MATCH EXACTLY!

If LC says “1,000 Brown Teddy Bears” but invoice says “1,000 Teddy Bears” — REJECTED! ❌

Why? Because banks don’t inspect actual goods. They ONLY check documents. One wrong word = problem.

Example of Rejection:

• LC says: “Port of Loading: Shanghai”
• Bill of Lading says: “Port of Loading: Shanghai Port”
• Result: DISCREPANCY! Bank may refuse payment.

✏️ Part 4: LC Amendment and Discrepancies

What is an LC Amendment?

Sometimes plans change. An amendment is an official change to the LC.

Example Changes:

• Shipping date extended (ship delayed by storm)
• Quantity changed (factory can only make 900 bears)
• Price adjusted (raw materials cost more)

How Amendment Works

graph TD
    A["🔄 Buyer requests change"] --> B["🏦 Buyer's bank sends amendment]
    B --> C[🏦 Seller's bank receives it"]
    C --> D["🏭 Seller agrees or disagrees"]
    D --> E["✅ If agreed - LC updated"]

IMPORTANT: ALL parties must agree to the amendment. No one can change an irrevocable LC alone!

What are Discrepancies?

A discrepancy is a mismatch between what the LC requires and what the documents show.

Common Discrepancies:

What Happens with Discrepancies?

1. Bank finds the error 🔍
2. Seller is notified 📞
3. Options:
   • Fix documents and resubmit
   • Ask buyer to accept despite errors
   • Payment gets delayed or refused

Real-World Tip: About 70% of LC documents have discrepancies! That’s why accuracy matters SO much.

🛡️ Part 5: Bank Guarantees Overview

What is a Bank Guarantee?

A Bank Guarantee is the bank saying: “If this person breaks their promise, I will pay you.”

It’s like having a rich uncle who says: “Go ahead and trust my nephew. If he doesn’t pay, I will!”

LC vs Bank Guarantee

Simple Comparison:

• LC = “I’ll pay when you prove you shipped”
• Guarantee = “I’ll pay if they mess up”

📝 Part 6: Types of Bank Guarantees

Just like LCs have types, guarantees have different flavors too!

1. Performance Guarantee

What it does: Promises the job will be done correctly.

Example: A builder promises to finish your house in 6 months. The guarantee says: “If builder doesn’t finish, bank pays you compensation.”

2. Payment Guarantee

What it does: Promises payment will be made.

Example: You hire someone and agree to pay in installments. The guarantee says: “If buyer doesn’t pay, bank pays the remaining amount.”

3. Advance Payment Guarantee

What it does: Protects money paid upfront.

Example: You pay $10,000 upfront for a machine. If the seller never delivers, the guarantee ensures you get your $10,000 back.

4. Bid Bond / Tender Guarantee

What it does: Ensures a bidder is serious about their offer.

Example: Company X bids $1 million for a government project. The bid bond means: “If X wins but backs out, the bank pays a penalty.”

5. Retention Guarantee

What it does: Replaces money held back for quality checking.

Example: Instead of holding 10% of payment until project completion, contractor gets full payment but provides a guarantee.

graph TD
    A["🛡️ Types of Guarantees"] --> B["⚙️ Performance"]
    A --> C["💵 Payment"]
    A --> D["🏁 Advance Payment"]
    A --> E["📋 Bid Bond"]
    A --> F["🔒 Retention"]

📢 Part 7: Demand Guarantees

What is a Demand Guarantee?

A Demand Guarantee is a super-strong guarantee.

The beneficiary (person protected) can claim money just by asking — no need to prove the other party did something wrong!

The Magic Words: “Payable on first demand”

How It Works

graph TD
    A["😟 Beneficiary claims payment"] --> B["📝 Sends written demand to bank"]
    B --> C["🏦 Bank checks demand is valid"]
    C --> D["💰 Bank pays immediately"]
    D --> E["🤔 Bank asks customer for money back"]

Example:

• Landlord has demand guarantee from tenant’s bank
• Tenant damages property but refuses to pay
• Landlord sends demand letter to bank
• Bank pays landlord immediately
• Bank then gets money from tenant

Why So Powerful?

• No investigation needed — Bank pays first, asks questions later
• Very fast — Money comes quickly
• Beneficiary is protected — They get paid even if there’s a dispute

The Risk

Because it’s so powerful, companies are careful about who they give demand guarantees to. The bank WILL pay if asked!

📞 Part 8: Guarantee Claims Process

When Can Someone Make a Claim?

A claim happens when the person protected by the guarantee says: “The other party broke their promise. Pay me!”

Steps in the Claims Process

graph TD
    A["1️⃣ Problem occurs"] --> B["2️⃣ Beneficiary prepares claim"]
    B --> C["3️⃣ Claim sent to bank"]
    C --> D["4️⃣ Bank checks claim validity"]
    D --> E{5️⃣ Claim valid?}
    E -->|Yes| F["6️⃣ Bank pays beneficiary"]
    E -->|No| G["❌ Claim rejected"]
    F --> H["7️⃣ Bank recovers from customer"]

What Makes a Valid Claim?

1. Within validity period — Guarantee hasn’t expired
2. Correct format — Matches what guarantee requires
3. Right amount — Doesn’t exceed guarantee limit
4. Proper declaration — States what went wrong (sometimes)

Example Claim Scenario

Situation: Construction company was supposed to build a school by December. It’s now February and school is not finished.

Claim Steps:

1. School board writes to bank
2. Letter says: “Company XYZ failed to complete construction by deadline. We claim $50,000 under guarantee number 12345.”
3. Bank verifies guarantee is still valid
4. Bank verifies claim is properly written
5. Bank pays school board $50,000
6. Bank asks construction company to repay the $50,000

Expiry Matters!

CRITICAL: Claims must be made BEFORE the guarantee expires!

🎯 Quick Summary

Letters of Credit = Payment Promise for Trade

Bank Guarantees = Promise Protection

🌟 The Big Picture

Trade finance tools like LCs and Guarantees are the invisible bridges that connect strangers across the world.

Without them:

• 👎 Buyers wouldn’t trust sellers
• 👎 Sellers wouldn’t trust buyers
• 👎 International trade would be scary and slow

With them:

• 👍 Strangers can do business safely
• 👍 Banks act as trusted referees
• 👍 World trade flows smoothly

You’ve just learned how billions of dollars move safely around the world every day! 🌍💰

Remember our toy buyer from the beginning? With an LC, they can buy 1,000 teddy bears from across the ocean, knowing they’ll either get their toys OR get their money back. That’s the magic of trade finance!