Back to the Basics: Types of Standbys & Demand Guarantees
Trade finance is complex. For bankers, lawyers, import/exporters, and corporates, the sheer volume of terminology in trade finance can be overwhelming, especially to those new in the field. Setting aside for a moment the tricky concept of the independence principle, there exist several different independent undertakings with different anatomy: commercial LCs, pre advices, reimbursement undertakings, and in some cases BPOs. While there are a number of elucidating publications and resources available from us at IIBLP, as well as the ICC and beyond, we've decided to start this blog series to cover some of the basics. This brings us to the subject of the types of independent standbys and demand guarantees.
Types of Standbys & Demand Guarantees
While standbys and demand guarantees are independent from the transactions that give rise to them, it is common to classify them by the types of transactions that they support. This classification is informal and has no significance in the application of the practice rules or law. It does, however, assist in understanding the provisions that are likely to be contained in the standby/demand guarantee and the pressures that will be placed on it. All of these classifications are applicable to standby LCs. They would apply equally to demand guarantees although in practice demand guarantees tend to be related chiefly to performance, namely advance payment, bid bond, and warranty types as well as performance of the undertaking. As will be seen, certain practice rules work better with certain types of standbys/demand guarantees.
The Introduction to ISP98 lists and explains the following classifications:
- A “Performance Standby” supports an obligation to perform other than to pay money, including for the purpose of covering losses arising from an Applicant’s default in completion of the underlying transactions.
- An “Advance Payment Standby” supports an obligation to refund or repay all or part of a Beneficiary’s advance payment to the Applicant. A “Bid Bond/Tender Bond Standby” supports an Applicant’s obligation to execute a contract if the Applicant is awarded a bid.
- A “Counter Standby” supports the issuance of a separate standby or other undertaking by the Beneficiary of the counter standby.
- A “Financial Standby” supports an obligation to pay money, including any instrument evidencing an obligation to repay borrowed money.
- A “Direct Pay” Standby supports payment when due of an underlying payment obligation typically in connection with a financial standby without regard to a default.
- An “Insurance Standby” supports an Applicant’s insurance or reinsurance obligation.
- A “Commercial Standby” supports an Applicant’s obligations to pay for goods or services in the event of non-payment by other methods.
Under the capital adequacy requirements of various national regulations resulting from the so-called Basel Committee of the Bank of International Settlements, classification of an independent undertaking as a commercial LC, performance standby/demand guarantee, or financial standby/demand guarantee affects the risk weighting of the undertaking. It is debated how a so-called commercial standby should be classified for purposes of risk weighting.
Key Standby LC & Demand Guarantee Resources:
While there are a number of free and paid resources available to those looking to increase their command of standbys & demand guarantees, including Bertrams' pricey book published by the ICC, we stand by the idea that late IIBLP founder James E. Byrnes' 2014 work is above all the rest. Standby & Demand Guarantee Practice: Understanding UCP600, ISP98, and URDG758 features not only a comprehensive introduction to international trade view through the lens of using financial standbys and guarantees, but it provides a framework by which bank operations personnel, lawyers, corporate LC users, or anyone else for that matter can apply the practice rules and understand their strengths and weaknesses in provided circumstances.
For those already regularly dealing with standbys and demand guarantees subject to the International Standby Practices (ISP98), IIBLP has several resources available, including the official companion volume to the rules.
Additionally, the Introduction to Demand Guarantees & Standbys highlights the use of guarantees and standbys in real world situations via the court cases that bring application problems to light.
The majority of this information is drawn from IIBLP's own book, Standby & Demand Guarantee Practice: Understanding UCP600, ISP98, and URDG758.