Jul 18, 2022
Lygon Explained #1: The bank guarantee process
A bank guarantee is a physical document issued by the bank on behalf of their customer, providing an unconditional and irrevocable undertaking to pay the holder the amount of the guarantee upon presentation.
This allows organisations to make commitments without the need to hand over cash and impact their working capital.
These paper-based documents are typically used as security for property or goods, for contracts to support things like construction works, or even used as a bond for performance milestones.
Who uses bank guarantees?
Applicant: The entity needing to lodge the security, e.g. a tenant in a shopping centre.
Beneficiary: The entity holding the security, e.g. a commercial landlord.
Issuer: The financial institution issuing the security, e.g. a bank.
Applicants range from sole traders to multinational corporations. Beneficiaries may be mum-and-dad landlords owning a single property to shopping centres, government organisations, or infrastructure such as ports and airports. Issuers can include small local banks to international financial institutions.
The history of bank guarantees
Bank guarantees originated in the Roman Empire, with the practice of a bank guaranteeing payment for a debt stemming from a law called “receptum argentarii.”
Whilst they may have been modernised to some degree since then, the process has remained the same for many years.
How does a bank guarantee work?
Many corporate applicants will have a bank guarantee facility with a designated credit limit to be utilised for a fee.
An applicant will request a bank guarantee – consisting of the parties’ names, amount, and expiry – issued by their bank to a beneficiary. This replaces the need to transfer cash or provide a corporate guarantee.
It typically takes over a month for the parties to agree on the details of the bank guarantee, due to the legal discussions and couriering of draft and final documents between parties.
If a guarantee needs to be amended or reissued due to expiration or error, the process must be started again.
The beneficiary holds this document for the duration of the time the guarantee is valid. Whilst the guarantee is in their physical possession, the credit risk is assumed by the bank rather than the applicant.
The problem with paper guarantees
Up until recently, bank guarantees have been exclusively paper-based instruments.
As bearer instruments with face values into the hundreds of millions of dollars, there is potential for trouble.
That means these documents need to be stored safely, delivered by secure couriers, and require an investment in staff to manage and maintain.
If the paper document becomes illegible, potentially from fire, flood, or age, the value of the financial instrument becomes void.
It also poses a security risk, as the paper nature of the documents means they can be lost, tampered with, or damaged.
The paper nature of the documents also creates a risk of fraud. From our research, there are 50 fraudulent paper guarantees per 20,000 in circulation.
This means 1 in every 400 Bank Guarantees in Australia is fraudulent.
Many long-term contracts have inflation-related clauses written into them. Due to the long lead time associated with amending the value of the guarantee, often beneficiaries will not update the value, exposing them to a shortfall in security.
We estimate there to be 400,000 guarantees in circulation in Australia. On average each paper guarantee is made of 10 pieces of paper and requires upwards of 2 deliveries per document.
Distributing paper documents around the world (in some instances repeating the process numerous times) has a significant environmental impact throughout the guarantee lifecycle.
Paper to Pixel: Digital bank guarantees
Why hasn’t it been done before?
Historically, all banks have different formats and legal language within their bank guarantees. Therefore, agreeing on a standardised document was challenging.
Creating a digital ecosystem for all three parties is not just creating a new product – it is a new way of working.
Lygon, as an independent piece of financial services infrastructure, achieved this by facilitating access to all parties, regardless of who they bank with.
This significant change is our platform, the Lygon Arc.
Lygon Arc replaces the outdated, paper-based process with a digital alternative.
Our platform reduces guarantee issuance lead time to as little as one day and provides users full visibility over their active guarantees in a dynamic dashboard.
With the click of a button, users can amend, demand (partially or fully), or cancel a bank guarantee.
Fraud, loss, or damage to the guarantee is significantly reduced with IBM’s Distributed Ledger Technology (DLT), underpinned by their Hyperledger Fabric.
The use of DLT also creates an immutable audit trail, allowing users to see the bank guarantee move through the approval process.
Finally, the Lygon platform removes the need to rely on countless pieces of paper, and the need for this paper to be delivered between parties and physical storage.
With these benefits on offer, market-leading organisations like Dexus, Mirvac and Buildcorp have already joined Lygon to begin accepting digital bank guarantees. To learn more, fill in the form on our "contact" page to speak to a member of our team.
From the blog
Lygon Explained #2: Applicants, beneficiaries and issuers
Paper vs digital: The hidden costs of the paper bank guarantee lifecycle