Bank Guarantees

Bank Guarantees are used primarily to finance trade. In this posting I will describe the aspects of a Bank Guarantee that make it a tradable security and why this trading activity attracts opportunists (read Intermediaries) in spades to get a piece of the action of this lucrative trade.

The large majority of Bank Guarantees issued by major trading banks worldwide have a term of just over a year (more specifically 1 year and 1 day). A bank will issue a bank guarantee to their (primarily corporate) clients based on the clients’ credit worthiness and their relationship with the bank. The client typically puts up between 50 to 60% of the face value of the bank guarantee. In other words, a bank may issue a bank guarantee of a certain face value to a client against a cash deposit by that client of between 50 to 60% of that face value. It is this feature of a bank guarantee of being issued at a discount to face value that makes it similar to a zero coupon bond and makes it a tradeable security.

The clients of a bank guarantee are large major trading corporations such as Nike or Apple and the face values of issued bank guarantees are typically US$ 500 million and up although they can certainly be issued with a face value of amounts lower than this. In addition to providing a negotiable instrument to transact international trade for these clients, the bank guarantee is also used by these clients as a means of raising extra capital by selling the bank guarantee.

The clients to whom the bank guarantee is issued may sell that bank guarantee to a third party (such as a securities house like Morgan Stanley) with a markup (usually 10 to 20%). The third party may then sell the bank guarantee to another private party (such as a pension fund) with another markup (again 10 to 20%). This private party may then choose to hold on to the bank guarantee and redeem it for full face value at maturity (at the end of the 1 year and 1 day period). It is important to note that the issuing banks themselves never enter into agreements to sell their financial instruments and a third party buyer’s bank will not enter into an agreement to purchase the financial instrument. The private agreement to trade the bank guarantee is always between the buyer and the seller. No banker or securities officer will act on behalf of the buyer or seller. That being said, this is where informed intermediaries come into the picture arranging private buy/sell transactions between buyers and sellers for a “consulting fee” of typically 1% of the transaction amount for the buyers and sellers representatives. When the face value of the bank guarantee is US$ 500 million in multiple tranches, the “consulting fee” for the introducing intermediaries can be a king’s ransom indeed. This is exactly what attracts the hoards of intermediaries and the broker chains.

Since Bank Guarantees are issued by banks to their clients for the first time (known as “fresh cut” bank guarantees in industry jargon), they do not appear on any Central Securities Depository screens such as DTC or Euroclear for screening, authentication, or settlement. The MT-103 is used to send a conditional SWIFT transfer of cash funds used for fresh cut bank guarantees. Hence settlement of payments for Bank Guarantees must be transacted through NON-Euroclear Delivery Versus Payment (DVP) procedures agreed in advance by transacting parties. Non-Euroclear DVP Protocol Settlement Procedures do not require such things demanded by intermediaries such as proof of funds, proof of capability, financial capability letter, MT-760 (Bank Guarantee), MT-543 (Bank Commitment), or MT-799 (Confirmation of funds on deposit). This is handled in the bank to bank call, after the contract between buyer and seller is signed and in place. Bank to bank confirmation of funds replaces any need for POF.

Subsequent sales of Bank Guarantees to third parties make them a “seasoned instrument”. There is no such thing as a “slightly seasoned instrument”. Bank Guarantee Instruments are either “fresh cut” which is a new issue to the bank's client that has never been sold to anyone yet or registered with a buyer or they are “seasoned” which is an instrument that has already had a registered owner. The prices of these seasoned instruments depends on the quality of the issuing bank (Bank Guarantees issued by AAA+ banks command a premium) and may be sold typically at 85 to 97% of the face value in these subsequent sales. If Bank Guarantees are sold to securities houses in subsequent sales, the securities houses may register the Bank Guarantee as a security and issue them a CUSIP or ISIN number but this is not the norm.

The key is that the initial applicant of the BG must, at some agreed upon later date, pay the issuing bank additional money No bank would allow a client to earn 40-50% per year in interest. However when the BG is sold to a 3rd party teh applicant may use the funds raised for investments and still pay the bank the money due at the end of the term.