Standby Letters of Credit

No. A letter of credit lets a financial institution act as a middle party for a transaction. It is a guarantee by a credit worthy financial institution, which makes it a mechanism for securing payment and performance obligations.

A documentary letter of credit (LC) is issued by a buyer of an international product or service. Documentary LCs are also known as commercial or payment LCs. This LC protects the seller, as a guarantee for payment moves from the buyer to the buyer’s bank once the LC is issued. This kind of LC also protects the buyer, as the issuing financial institution (typically the buyer’s bank) will hold funds until documents are received from the seller. When a seller makes a demand that complies with the letter of credit, the financial institution is obligated to pay.

A standby letter of credit, in contrast, is a form or security for a future performance or financial obligation. Whether the LC is called or not depends on whether the issuer has performed or paid the financial obligation. This type of LC “stands by” until if or when a beneficiary demands on the instrument.

When a standby letter of credit has this clause included, it does present extra risks for the applicant. With this type of clause, the applicant and issuing financial institution needs explicit consent from the beneficiary to cancel the letter of credit otherwise it will automatically renew at each renewal period.

Letters of credit and surety bonds are types of performance bonds.

A letter of credit is a guarantee made by a financial institution on behalf of a business, typically the financial institution’s customer. The demand on the instrument is a monetary demand only and typically represents a portion of an underlying contract or financial obligation.

A surety bond is a three-way contract between the principal, the surety and the obligee. The surety financially guarantees to the obligee that the principal will act according to the terms of the bond. Surety bonds are insurance products and not offered by ATB.

Bank guarantees and letters of credit are similar in that they provide the confidence a transaction needs to go forward. A letter of credit ensures that a deal goes ahead, whereas a bank guarantee reduces losses if a transaction doesn’t go to plan.

No matter the type, acquiring every kind of letter of credit begins with a conversation between you and your financial institution. (If that’s us, great! Reach out to your usual ATB contact or use the information below.) Please note that standby letters of credit and guarantees require authorized credit facilities for their full amount.

If the payment demand is in compliance with the terms of the letter of credit, the issuing financial institution pays the beneficiary under the terms of the letter of credit. However the issuing institution will only determine the validity of the draw, not the validity of the reason for the draw.