Letter of Guarantee

A letter of guarantee is a bank-issued commitment that a supplier or creditor will be paid if the bank’s client (the buyer or debtor) defaults. It acts as a form of insurance for the recipient, giving confidence to proceed with transactions when one party’s ability to pay is uncertain.

How it works

• A customer applies to a bank for a letter of guarantee much like applying for a loan.
• The bank reviews the customer’s credit and financials and negotiates how much of the obligation it will cover. The letter may not cover the entire value of the underlying obligation (for example, it might cover principal or interest, but not both).
• If the customer defaults, the bank pays the guaranteed amount to the beneficiary. The bank typically charges an annual fee (a percentage of the guaranteed amount).

Common uses

Letters of guarantee are used in many business contexts, including:
* Domestic commercial contracts and construction projects
Financing arrangements and major purchases of equipment or property
Import/export transactions and customs declarations
Real estate investments, mergers and acquisitions, and other large transactions
Situations where a buyer is new to a supplier or a startup needs to demonstrate purchasing capacity

Letter of guarantee for call writers

Banks can issue letters of guarantee for options traders (call writers). When a writer shorts calls but holds the underlying securities at a custodian bank (not the broker), the issuing bank can guarantee to deliver the underlying securities if the call is exercised. The letter must meet the exchange’s and possibly the Options Clearing Corporation’s required form. Brokers accept these letters as a substitute for holding cash or securities when they judge the arrangement acceptable.

Examples

1. Purchase of customized equipment: A buyer orders a $1 million custom machine that won’t be completed for months. The supplier requires assurance of payment before investing time and materials. The buyer obtains a letter of guarantee from its bank; the supplier proceeds knowing the bank will pay if the buyer defaults.
2. Options/called stock example: A call writer with 10 short contracts (representing 1,000 shares) mitigates unlimited upside risk by owning 1,000 shares in another account. If the broker requires proof, the writer may provide a bank letter of guarantee confirming ownership and promising delivery if assigned.

Cost

Fees vary by issuer and deal risk but typically range from about 0.5% to 1.5% of the guaranteed amount per year. Terms and pricing are negotiated with the issuing bank.

Letter of credit vs. letter of guarantee

• Letter of credit: Commonly used in international trade; the issuing bank pays the beneficiary upon presentation of specified documents showing compliance with contractual terms.
• Letter of guarantee: Often used for domestic contracts and broader commercial guarantees; the bank promises to pay if the client fails to meet the contractual obligation. The two instruments can overlap in function but differ in formality, usage patterns, and document requirements.

How to obtain one

• Apply at a bank or financial institution (preferably one with an existing relationship).
• Provide detailed financial information for the bank’s credit assessment.
• Negotiate the scope of coverage, fee, and any collateral or covenants the bank requires.
• Obtain the letter in a form acceptable to the beneficiary and, if relevant, to any exchange or clearing organization.

Conclusion

A letter of guarantee provides suppliers or creditors with a bank-backed promise of payment, facilitating transactions where trust or credit history is limited. It reduces counterparty risk, enabling businesses to undertake larger or riskier deals while the issuing bank assumes the contingent obligation in exchange for fees and appropriate underwriting.