What Is a Demand Guarantee?
A demand guarantee is a type of protection that one party (the beneficiary) in a transaction can impose on another party (the principal) 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 from the guarantor, which the second party will be required to repay.
- A demand guarantee is an agreement issued by a bank to pay a specified amount to one party of a contract on-demand as protection against the risk of the other party's nonperformance.
- If the principal fails to perform on the contract, the beneficiary can demand payment on the guarantee from the guarantor, who can then seek repayment from the principal.
- Standard rules for demand guarantees in international trade are published by the International Chamber of Commerce (ICC) and have been widely adopted around the world.
- Demand guarantees are a way of managing, pricing, and transferring the risk of nonperformance among parties in order to facilitate transactions that might otherwise not be possible due to the risks involved.
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.
The International Chamber of Commerce (ICC) publishes uniform rules for demand guarantees for use in international trade contracts. The World Bank incorporated updated ICC rules as part of its collection of model contract forms in 2012. The revised rules set out the rights and responsibilities of the parties; the process and conditions for claims of payment; and guidelines for the amendment, transfer, or expiration of demand guarantees. The ICC rules have been adopted for use as a standard by banks and national governments around the world.
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.
Economics of Demand Guarantees
In economic terms, a demand guarantee is a way for one party to assume all the risk that they might fail to perform on the contract. this can induce the counterparty to be more willing to enter into the agreement and, at the margin, allow some mutually beneficial transactions to take place that otherwise might not happen. This is particularly the case with especially risky types of transactions or parties.
The cost of a party's risk of nonperformance will be reflected in the price that they pay the bank or other guarantor for the demand guarantee. This price can be absorbed fully by the party purchasing the guarantee, or some of this cost may be passed on to the beneficiary of the guarantee implicitly by pricing it into the terms of the contract.