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A bank guarantee and a letter of credit are similar in many ways but they're two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn't go as planned.

A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed.

A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary. Unlike a letter of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

For example, an American wholesaler receives an order from a Canadian company. The wholesaler has no way of knowing whether the buyer can fulfill his payment obligations, and requests that a letter of credit be provided in their contract. The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged. The letter of credit substitutes the bank's credit for that of its client, ensuring correct and timely payment.

Bank guarantees insure both parties in a contractual agreement from credit risk. A construction company and its cement supplier may enter into a new contract to build a mall. Both parties may have to issue bank guarantees to prove their financial stance and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank which then pays the company the agreed amount specified in the bank guarantee.

While letters of credit are used mostly in international trade agreements, bank guarantees are often used in real estate contracts and infrastructure projects.

For further reading, see What Is International Trade?

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