What is a Demand Guarantee?
A demand guarantee is a type of protection that one party in a transaction can impose on another party in the event that the second party does not perform according to predefined specifications. In the event that the second party does not perform as promised, the first party will receive a predefined amount of compensation by the guarantor, which the second party will be required to repay.
Understanding Demand Guarantees
A demand guarantee is usually issued in lieu of a cash deposit. This may be done to preserve the liquidity of the companies involved, particularly if there isn't enough free cash on hand. While this situation can be seen as a solvency issue leading to counterparty risk, the demand guarantee can help a company with limited cash reserves continue to operate without tying up more capital while also reducing the risk for the party receiving the guarantee.
Banks typically issue demand guarantees and they are also used to process payment of the guarantee. For example, an importer of cars in the U.S. can ask a Japanese exporter for a demand guarantee. The exporter goes to a bank to purchase a guarantee and sends it to the American importer. If the exporter does not fulfill its end of the agreement, the importer can go to the bank and present the demand guarantee. The bank will then give the importer the predefined amount of money specified, which the exporter will be required to repay to the bank.
A demand guarantee is very similar to a letter of credit except that the demand guarantee provides much more protection. For instance, the letter of credit only provides protection against non-payment, whereas a demand guarantee can provide protection against non-performance, late performance and even defective performance.
How a Demand Guarantee Is Implemented
A demand guarantee might also be called a bank guarantee, a performance bond or an on-demand bond depending on the usage. For example, a performance bond can be issued by an insurer or a bank to guarantee that a party fulfills its obligations in a contract. How a demand guarantee is implemented and enforced can vary by legal jurisdiction. In some countries, a demand guarantee is separate and independent from the underlying contract between the parties in question.
There is an element of risk in agreeing to a demand guarantee. The first party need only present the demand guarantee to the bank in most cases and request payment. This can be done without providing documentation that shows the second party failed to meet its obligations to the first party. This can expose the second party to being penalized by the first party, even if it has fulfilled its contracted duties.