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The mechanics of bank SLCS and guarantees 
(Source: Unknown Economist / Accountant of a Major US Corporation under direction of its Board of Directors)

The driving force behind the financial instruments under discussion in this paper is the U.S. government through its monetary agency, the Federal Reserve Board. The U.S. dollar is the basis of the world's liquidity system since all other currencies base their exchange rate on it. Quite simply this means that the U.S. is the world's central banker. As the world's central banker, the U.S. has an enormous responsibility to maintain stability in the world's monetary system. As well, the U.S. as the most powerful nation has accepted the role as the champion and promoter of democracy in all of its endeavors. While the U.S. has many tools to do this, one in particular is relevant for the purposes of this discussion.

The Federal Reserve Board (Fed) uses two financial instruments to control and utilize the amount of U.S. dollars in circulation internationally: Standby Letters of Credit (SLC) and Bank Guarantees (BG).

The Fed's domestic tools to control credit creation are interest rate policy, open market operations, reserve ratio policy and moral persuasion. In the domestic context, these tools are not always as effective as the Fed would like them to be. Part of the reason for the less than perfect effectiveness is due to the substantial stock of U.S. dollars in foreign jurisdictions. Several of the Fed's domestic tools cannot be used by it in other countries. For examples, the Fed cannot change foreign reserve ratios.

Furthermore, a significant amount of credit creation occurs in U.S. dollars in foreign countries, particularly in the Eurodollar market. The Fed cannot control the credit creation in foreign markets through its use of domestic policy instruments. Internationally the currency of choice is the U.S. dollar as it is considered the safest currency, especially in times of political crisis. Consequently those holding the dollar do so for reasons which are less sensitive to economic stimuli.

Because foreign banks readily accept U.S. dollar deposits, those funds, which in the domestic context are the basis of M1 money supply, in the foreign context, they act more like the near money features of M3. This means they are infinitely more difficult to control. The offshore market has grown substantially in the last two decades for a number of reasons. First, huge quantities of U.S. dollars associated with the drug trade slosh around the international monetary system, and second, wealthy individuals concerned about high taxes and preserving their wealth opt to keep their assets in offshore tax havens. This significant stock of U.S. dollars cannot be effectively controlled by the U.S. with its normal domestic policy tools. Finally, currency futures markets can be another difficult area to control because of the substantial amount of leverage that is available. For example, for as little as $1500 dollars, it is possible to short or go long for over $150,000 U.S. dollars versus the D Mark. All other major currencies have a similar leverage on the dollar.

This means that someone with $1500 U.S. dollars can take the other side in a Fed move to stabilize the currency. Since the currency does not have to be delivered, but the contracts are rolled near the expiry date, it is possible to create substantial pressure on the dollar in either direction. (The Hunts learned this the hard way when they tried to corner the world silver market.) To control U.S. dollars outside the U.S., the Fed resorts to Standby Letters of Credit or, as they are popularly known, SLCs.

In its more familiar domestic form, the SLC is a financial guarantee or performance bond issued by a bank for a fee on behalf of a customer that wishes to borrow funds but in unable to do so cheaply in credit markets. A bank guarantees the borrower's financial performance to the lender by issuing the SLC. Since the bank is in a better position to assess credit risk and demand collateral, the issuance of this form of guarantee is a natural service that a bank provides. In the international markets the use of SLCs is somewhat different.

It simply is a money-raising device where the financial guarantee is almost meaningless. Banks issue these SLCs on behalf of the Fed; in other words, the Fed is the customer of the bank. Obviously there is no credit risk here. The net proceeds from the funds raised are immediately wired to the Fed. Using this method, the Fed can reduce the U.S. dollars in circulation in foreign jurisdictions. Using a different method, the large stock of expatriated dollars is employed by the Fed to promote U.S. foreign policy.

For example, during the G7 meeting in Tokyo in April of 1993, the U.S. committed financial aid to Boris Yeltzin to the tune of $6 billion. These funds do not come form the U.S. Treasury, nor is the merit of the loan debated in the U.S.  Congress. Instead, the U.S. taps the international pool of U.S. dollars through an instrument called a Bank Guarantee (PBG). Essentially the instrument has the features of an SLC except it is longer dated with 10 and 20 year maturities. Unlike SLCs which sell at a discount and bear no interest, PBGs bear a coupon payable annually in arrears.

Like the SLC, it is a form of guarantee ensuring the lender will receive interest as is due and be repaid the principal upon maturity. It is important that the U.S. has these tools to control the dollars that increasingly grow off its borders. The Fed operates its currency stabilization so effectively through the use of SLCs that it seldom resorts to intervening in the foreign exchange markets.

Rather than the U.S. government tapping the domestic savings pool to assist foreign governments, it is able to tap the international pool of expatriated U.S. dollars that leak away from its shores in hundreds of millions daily.

Recommended further reading:
ICC endorsement of the UNCITRAL Convention on Independent Guarantees and Stand-by Letters of Credit
Letters of Credit (LC, ILC & Pay Order)
Documentary and Standby letters of Credit
Standby Letter of Credit and Builders Letter of Credit by the New York State Banking Department
Letters of Credit by Michael Rowe