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A confirmed letter of credit is an important document to those who are launching or running a business, particularly those engaging in international trade. These letters are used to help protect both the business and their vendor. They essentially involve a bank guaranteeing payment of a transaction, which can inspire confidence and allow a deal to go through.

Here, we’ll take a closer look at this document and learn:

•   What a confirmed letter of credit is

•   How a confirmed letter of credit works

•   What a letter of credit contains

•   The advantages and disadvantages of a confirmed letter of credit

What Is a Confirmed Letter of Credit?

Here’s what a confirmed letter of credit is: Also known as a confirmed LC, it is an additional guarantee for a payment by a secondary bank. It states that this additional bank will be responsible for a payment being on time and in full even if the buyer doesn’t meet their contractual obligations and the first bank (called the issuer) can’t make payment or in default. You might think of it as a kind of insurance policy or Plan B if the initial bank responsible for payment failed to do its job.

This type of document can be common in international trades, such as in export and import businesses. In many cases, a guarantee may be required to conduct international transactions or when a vendor or seller has reason to doubt the first bank’s creditworthiness.

How Confirmed Letters of Credit Work

Confirmed letters of credit are commonly used as negotiable instruments, which are signed documents that promise to pay a certain sum to a specified person. It’s especially valuable in international business transactions that involve a significant payment amount for goods or services. Since the letter acts as guaranteed payment, it may take the place of a request for advance payment. (This can be helpful if an individual had been, say, considering taking out a loan to enhance their credit.)

To get a letter of credit, the buyer will likely need to submit required documents to the first bank, including proof that certain steps have been completed. Then the bank will send appropriate documents to the seller’s bank. This paperwork shares detailed instructions on the terms and conditions, as well as how payment should be made. Depending on the agreement between the buyer and the seller, payment may be made immediately or at an agreed-upon date.

Once the letter of credit has been issued, the buyer needs the backing of a second bank to get a confirmed letter of credit. Worth noting: A fee is likely to be involved. The exact amount of this fee may depend on how good (or questionable) the first bank’s credit is. This letter usually reflects the first letter of credit and uses the same terms.

A confirmed letter of credit can protect both parties because it decreases the risk of default for the vendor or seller. Additionally, it ensures that payment is only made if all the terms are met. It can be a step to building good credit when doing a deal with a new client. It can also be helpful for a business that is just starting out and making connections, building contacts, and monitoring its credit.

Parties Involved in a Confirmed Letter of Credit

The following are all the parties typically involved in a confirmed letter of credit:

•   Buyer or applicant: This is the party who is requesting the letter of credit and who will pay the seller.

•   Beneficiary or seller: The party who is selling goods or services and is the one who receives payment.

•   Issuing bank: This is usually a bank where the buyer already has a business bank account. It’s the one that issues the original letter of credit.

•   Confirming bank: This is the second bank that will guarantee the funds to the seller once the terms in the letter of credit are met. In some cases, the confirming bank is from the seller’s home country (this may be called a correspondent bank) or is a bank the seller already works with.

Confirmed Letter of Credit Example

Let’s look at an imaginary example of how a confirmed letter of credit could work. Say that Pauline’s Paper Goods receives an order for 100,000 pallets of customized notebooks from JessCo, a stationery company. Pauline’s Paper Goods has never worked with JessCo before and isn’t sure that this company has the means to pay for the goods. Maybe Pauline’s Paper Goods worries that JessCo doesn’t have what is considered good credit.

In order to prevent non-payment after the notebooks are produced and shipped off to the buyer, Pauline’s Paper Goods outlines an agreement that JessCo needs to pay with a confirmed letter of credit on the date the shipment leaves their warehouse.

If JessCo agrees, it would start applying for a letter of credit at its bank, where it has its checking account, in the United States. If the bank requires it, the company needs to provide proof it has the funds available or it will apply for financing.

As soon as the issuing bank creates the letter of credit, JessCo then applies for a confirmed letter of credit with another bank, possibly the seller’s bank. When Pauline’s Paper Goods receives the completed confirmed letter, it manufactures and ships the customized notebooks. Once Pauline’s Paper Goods provides proof of when and how the goods were shipped, the guaranteed funds are released.

Confirmed vs Unconfirmed Letters of Credit

If you are conducting international business, you will probably hear the terms confirmed and unconfirmed letters of credit. An unconfirmed letter of credit is simply a letter of credit issued by a bank. A confirmed letter of credit, as we’ve described above, is backed by two banks. This can foster trust if, say, there’s reason to worry the payment won’t be made. (Perhaps one company involved has a less than stellar credit rating; this is one situation that shows why bad credit can be a big deal.)

The following are other differences between the two:

•   Guaranteed payment: With a letter of credit, the issuing bank guarantees payment. With a confirmed letter of credit, however, two banks confirm payment.

•   Cost: Unconfirmed letters of credit tend to cost less than confirmed letters of credit.

•   Changes: The buyer is allowed to make changes to an unconfirmed letter of credit. With a confirmed letter of credit, both banks can modify the document.

•   Issuance: The seller only has to approach one bank for an unconfirmed letter of credit, but needs to contact two with a confirmed letter of credit.

Advantages of Confirmed Letters of Credit

Confirmed letters of credit can have several benefits for sellers, particularly those doing business internationally and wanting to ensure smooth transactions. These advantages include:

•   Protection for both the buyer and seller

•   An extra layer of confidence for the seller

•   A lower risk of default thanks to a reputable second bank (perhaps serving as a guarantor if the first bank has a credit rating that varies)

•   Buyers can seem more creditworthy, which may increase the odds that a seller will do business with them

Disadvantages of Confirmed Letters of Credit

While confirmed letters of credit can be very valuable in business, there are a couple of downsides to recognize. Disadvantages of confirmed letters of credit include:

•   It may take longer to get a confirmed letter of credit since an additional bank is involved

•   Bank fees may be higher than with an unconfirmed letter of credit

The Takeaway

A confirmed letter of credit can be a valuable business tool, especially when conducting international business. For those importing or exporting, the letter will guarantee payment for goods a company is supplying if the buyer and the buyer’s bank can’t complete the deal. Getting a confirmed letter of credit may cost more and take longer compared to an unconfirmed letter of credit, but the effort may be worth it. It can secure a transaction and open doors to doing business with new customers in a way that communicates confidence.

Having confidence in your banking partner is an important aspect of your financial life. That’s why you may want to give SoFi a closer look for your personal accounts. SoFi may be just the right match. Here’s why: When you open an online bank account with direct deposit, you won’t pay any fees (no account, monthly, minimum-balance or overdraft charges). You will, however, earn a super competitive APY. In other words, your money could grow faster.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.60% APY on SoFi Checking and Savings.

FAQ

What is an unconfirmed letter of credit?

An unconfirmed letter of credit is a letter of credit that’s only been issued by one bank, known as the issuing bank. In a transaction, the buyer requests an unconfirmed letter of credit to guarantee funds will be paid on time to the seller by the bank.

Is an unconfirmed LC safe?

Yes, it’s safe because there is guarantee or confirmation from one bank that payment will be made. Assuming that the issuing bank has a high credit rating, the seller can feel confident that the funds will be paid once all the conditions in the contract have been met. If the seller wants an additional layer of security, they may request a confirmed letter of credit — which means a second bank will guarantee payment if the first one fails to do so.

What is the risk of an unconfirmed LC?

The risk of an unconfirmed letter of credit is that the issuing bank won’t have the funds to pay the seller. That means even if the seller completes their end of the contract, they risk losing out on funds if the issuing bank doesn’t fulfill their promise.

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SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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These days, most of us do all kinds of tasks online. From scheduling a yoga class to booking a dinner reservation to ordering more toothpaste instead of grabbing it from a store, our smartphones and computers make it easy.

Still, there are some folks who don’t feel comfortable conducting their banking online. They worry perhaps that they’ll hit the wrong button and send thousands of dollars speeding off into unknown parts of the ether. Or maybe having a physical bank makes them feel more at ease, is more familiar to them, and they feel like their money is safer.

Those who prefer to do online banking may like the convenience of 24/7 access to their money. They may not have the time or inclination to wait in line or chat with bank tellers.

But is one style of banking better than another? To answer that question, let’s examine some pros and cons of digital banking.

Once we’ve examined these benefits and downsides of online banking, you can make an informed decision about what kind of banking is right for you. Maybe it’s even a combo of the two styles. Then, we’ll talk about how to move your banking to an online-only platform if that’s what suits you.

What Is Online Banking?

Consumers have a few different options when it comes to where they park their money and use it to complete transactions. The traditional options are to use a commercial bank with bricks-and-mortar branches or a credit union. A credit union is a financial co-op that is generally owned and operated by its members (as opposed to being a publicly-traded company).

Most traditional retail banks offer mobile banking as well as the ability to conduct business at a branch. Mobile or online banking in this sense allows you to look up your accounts and complete transactions online (more on the difference between the two terms in a minute). Typically, this means you can transfer funds and even mobile deposit checks.

But these added services are not what we are talking about today; here, we are discussing the use of an online-only or an internet-based bank versus a traditional bank. Online-only banks are a newer alternative to traditional banks. Sign up for a digital bank, and you will do all of your banking operations online. Online banks generally have no physical locations, which can help them to keep overhead costs low. In turn, they typically pass those savings on to you and offer some perks over traditional banks, such as a higher interest rate on savings accounts.

Because not all digital banks are the same, the following list of pros and cons won’t capture every nuance, but hopefully you’ll get an idea of what services are offered. Knowing these details should help you evaluate the benefits of both mobile banking and traditional banking and which one suits you best.

Recommended: Is Mobile Banking Safe?

Pros and Cons of Online Banking Services

If you’re used to turning up at your local bank branch and chatting with the tellers, digital banking may seem like a big shift. Or perhaps you’re a person who is already using mobile banking but you wonder if you’re missing out on any perks. In either case, take a look at what digital banking can offer. Here’s an assessment of the pros and cons of online banking.

Pros of Online Banking

Technology can offer some tremendous conveniences and perks to banking. Consider these pros of online banking:

Higher Interest Rates

As mentioned, banks without bricks-and-mortar locations tend to offer a higher rate of interest on cash savings accounts. Currently, the national interest rate on savings accounts is 0.06%.

This is a mere $.60 per $1,000 over the course of a year. On the other hand, an online bank is likely to pay 1% annual percentage yield (APY) or more, which amounts to $10 for every $1,000. This is obviously a significant improvement.

Recommended: APY vs. Interest Rate: What’s the Difference?

No Minimum Balance

Many traditional banks still require that you maintain a minimum balance or have an established automatic deposit or they will charge you a monthly fee. You may wonder how much money you need to open an account online. Some digital financial institutions do not require a minimum amount of cash be kept in your checking and savings accounts. Your balance in a digital bank account can be just a few dollars, and you still won’t be hit with charges on your statement.

Convenience

Online banks are open 24 hours a day, which some customers find useful for maintaining their finances and making transactions after normal bank hours. All you need is secure access to the internet. If you’re working an 8-to-6 job where you can’t sneak out to meet with a teller, the convenience of banking outside working hours is a gamechanger. Also, as we lead more fluid existences (say, working from home), there’s simply the time savings of being able to bank where you are versus walking or driving to a branch.

ATM Access

Most online banks will be part of an online network of ATMs, such as MoneyPass or Allpoint. There is generally no fee to use the ATMs, and customers can locate them online. If they do not use an ATM network, they will typically offer to refund ATM fees up to a certain number of withdrawals.

Cons of Online Banking

Of course, digital banking isn’t perfect. What is? There are some potential downsides to managing money this way, though many of them depend on your particular personal finance style. Here, some cons of online banking to keep in mind:

No Live Assistance

While most online banks provide a customer service line, they generally do not offer personal bankers. This means that there is no “live” person to help you with your banking needs, such as setting up accounts, applying for loans, getting a notary, or even just someone with whom you can discuss a simple issue or complaint. If you are a person who wants this kind of personal connection, you may not be well-suited to digital banking.

A personal relationship with a banker could come in especially handy in the event that you are trying to secure a loan at the best rate or have a business that you are looking to expand via borrowed funds. This is a person who knows and trusts you and could potentially make a difference in whether or not a bank will issue a loan.

Limited Access

Online banks typically keep their fees low and interest rates higher by offering limited services. They may or may not offer debit or credit cards; you may or may not be able to deposit physical cash, and if you can, there may be limits on how much or how often. Every online bank is different, so do your research on the services they offer.

Limited ATM Access

Although many online banks will have a network of ATMs that customers can access, they may not be as easy to track down as ATMs for the major retail banks. It’s worth spending time to see exactly where a digital bank has allied ATMs near your usual haunts, like your home and office, before signing up.

What Is the Difference Between Mobile Banking and Online Banking?

It’s not uncommon for people to use the terms mobile banking and online banking interchangeably, but there is a difference.

•   Mobile banking refers to the kind of banking you can conduct when you download an app and use it on a cellphone or a tablet.

•   Online banking is the sort of banking you do when you connect via a secure WiFi connection, meaning you might be using a laptop to check your balance or transfer funds.

Both of these are ways that you can manage your money without turning up at a physical bank. Wherever you are, as long as you have a secure internet connection, you can pay bills, move money between your checking and savings accounts, and see how much interest you’ve earned, among other things.

Security of Traditional and Online Banks

There is often a misunderstanding about security at banks. People worry, Will my online account be hacked? Are online savings accounts safe? The truth is, traditional banks are no more or less secure than online-only banks. Any bank that is insured by the FDIC guarantees the same amount of insurance in the event that the bank goes under $250,000, regardless of whether the bank is online or not. Digital banks generally tend to offer similar fraud protection programs as bricks-and-mortar banks.

Security typically has more to do with whether you use your debit card only on protected sites, do not access your banking information on a public computer, and avoid accessing private information while on public Wi-Fi networks. Unfortunately, even people who do everything right and take all of the proper precautions still find themselves the victims of some kind of bank fraud. Sometimes, it can only be attributed to bad luck.

How Do I Open An Online Account?

It all depends on the bank, but these banks generally have made it easier than ever to open up accounts. The process can likely all be done online, so you don’t have to sign and return physical paperwork.

Usually, opening a digital bank account requires two steps: First, you open an account at the new bank. To do this, you will have to answer a series of questions, and you will likely need to provide personal identification information like your Social Security number, date of birth, and more.

Next comes funding the online bank account, which can be done with a check or via a funds transfer. Usually, you are able to pull the assets into the new bank account by linking to an existing account you own. Most of the time, the sign-up process can be done in a matter of minutes, and you’ll be ready to start using your digital bank account.

💡 Recommended: What Do You Need to Open a Bank Account Online?

The Takeaway

Whether you call it online banking, mobile banking, or digital banking, the concept of doing all of your keeping your accounts at an online-only bank offers many rewards. You’re likely to earn higher interest and pay fewer fees, for instance. But for those who like banking in person at a branch and having a relationship with the team there, then it may not suit you. Think carefully about what suits your personal financial style best and will keep you on top of your money matters.

If you do think an online bank might be for you, come see what SoFi offers. When you open a new bank account with direct deposit, you’ll enjoy a terrific APY, none of the usual monthly, minimum-balance, and overdraft fees, plus you’ll be able to access your paycheck up to two days early.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.60% APY on SoFi Checking and Savings.

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SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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An ACH debit block is a fraud protection tool: Companies can opt into it to prevent any ACH debits and credits from their bank account. If you suspect that your business is a victim of fraud, an ACH debit block is an easy way to protect your money until you’ve resolved the issue. It can also be a good general practice to discourage unauthorized debits.

In this guide, you’ll learn:

•   What ACH blocks are and how they work

•   The benefits of an ACH debit block for small businesses and enterprise companies

•   An alternative solution to ACH debit blocks

How ACH Debit Block Works

Before you dive into how an ACH debit block works, it’s important to understand some of the basic concepts related to this process, such as the ACH system in general and debit blocks.

What Is ACH?

ACH (Automated Clearing House) is a common payment method that works like a digital check, transferring money from one bank account into another. A common example of an ACH transfer is a direct deposit from an employer into an employee’s checking account.

As an individual consumer, you may also make ACH payments yourself. For example, you might be using ACH when you utilize peer-to-peer payment apps like Venmo, pay your bills online, digitally file and pay your income taxes, or even transfer money over to an investment account like SoFi Invest.

What Is a Debit Block?

Businesses use ACH payments as well, to collect funds and pay expenses. But these can be a target for criminal activity. Scammers can try to pull funds out of your bank account without your approval. If you want to prevent money from leaving a business account via ACH because of this potential risk, an ACH debit block might be a good move.

When enabled, a debit block would impede your company from being able to use the funds in the account in all ACH use cases. It’s important to understand the ramifications of a debit block — and only request one from your bank if your company has alternative methods (or accounts) for making payments.

How Does an ACH Debit Block Work?

An ACH debit block is very straightforward. When this fraud management tool is implemented on a bank account, no one will be able to withdraw funds from the account via ACH.

If you have a debit block on a business account and need to make an ACH payment from that account, you’ll need to take action to make sure it goes through. It’s important to contact your bank to authorize that specific payment before the payment recipient begins the ACH debit process. Otherwise, you will need to make all future payments with paper or electronic checks, debit cards, credit cards, cash, or wire transfers.

Recommended: Understanding ACH Returns

Benefits of ACH Debit Block

ACH debit blocks can make payments difficult, so why would your business ever get one? It’s all about fraud — and not wanting to be a victim. Here’s a closer look at the advantages of using an ACH debit block.

Reduces Electronic Payment Fraud

One reason to enact an ACH block on a business account is if you suspect your account has been compromised. An ACH debit block can prevent fraudsters from being able to debit money electronically from an account.

An ACH debit block is just one fraud tool available to businesses. Other actions to take if you believe your bank account has been compromised might include contacting business credit bureaus and filing a report with the Federal Trade Commission (FTC).

Individual consumers who are victims of identity theft can also do more than contact their bank. If you believe your identity has been stolen, other steps to consider include filing a police report, reporting the fraud to the FTC, notifying the consumer credit bureaus, and contacting your creditors.

Offers an Additional Security Layer

Debit blocks are sometimes a reactive solution. That is, once a business suspects fraud, they can contact their bank to implement an ACH debit block on the account.

However, some companies — those that don’t need to make electronic payments from a specific business account — may prefer to proactively set up a debit block as an additional security layer. If you do so, just understand that you’ll need to contact your bank every time you want to authorize an electronic payment from your account.

Recommended: How Long Does Direct Deposit Take?

Setting Up an ACH Debit Block

Setting up an ACH debit block is easier than setting up direct deposit. Just call your bank, provide your credentials, and request that they set up debit block immediately. If you are doing this in response to fraudulent account activity, mention that on the call to determine what additional steps you should take.

Removing the debit block or authorizing a one-time payment will follow the same process. Contact your bank over the phone and explain exactly what you need.

Positive Pay vs ACH Debit Block

While an ACH debit block can be a good way to protect your business checking account, it does have its drawbacks. As an alternative, you may be able to implement positive pay.

Positive pay is an ACH filter that allows you to create a list of payees or vendors that will be automatically approved when they initiate an ACH debit from your company’s account. Certain criteria for these funds transfers can also be established. For example, you might put a cap on how much they can debit in a single transaction.

If any other individuals or businesses attempt an ACH withdrawal from your account, you will receive an alert. You can then review the request and approve or deny the ACH transfer.

Positive pay is more hands-on than ACH debit block but can be helpful if you have a list of recurring ACH payments. Positive pay may also be useful because it allows your company to review any unauthorized requests instead of having your bank flat-out reject them without a review, as with ACH debit block.

Worth noting: Because each bank’s offering is different, there might sometimes be an overlap between a debit block and positive pay. Some banks, for example, allow you to review and approve vendor payments when you have an ACH debit block enabled.

Recommended: Understanding ACH Fees

The Takeaway

ACH debit blocks are a secure way to prevent fraudulent electronic transfers from your company’s bank account. If you suspect that your bank account information has been compromised, contact your bank to initiate an ACH debit block and ask what other fraud prevention resources they can provide.

When thinking about your bank’s security, don’t forget about your personal accounts. SoFi is one great option to keep your money safe. Our online banking app is a fee-free option. You’ll earn a competitive APY and get early access to your paycheck. We also offer several security and fraud protection features, including in-app debit card freezes, suspicious activity monitoring, chip card technology, travel notices, and two-factor authentication.

Bank better and super securely with SoFi.

FAQ

Can ACH payments be blocked?

A business can block ACH payments with a feature called ACH debit block. This prevents anyone from electronically withdrawing money from its bank account. You may also be able to set up positive pay, which allows you to approve a list of electronic payments and review all other ACH requests.

How do I stop unauthorized ACH payments?

Set up an ACH debit block (typically, this is for business accounts) to prevent any electronic withdrawals from an account. If you want to allow expected ACH payments to process uninterrupted, set up positive pay, allowing only approved payments to go through. For your personal accounts, you may be able to set up alerts every time an ACH debit occurs in your account. If you notice any unauthorized activity, report it to your bank immediately.

What happens if an ACH transfer fails?

If the initial ACH transfer is not processed, some companies may attempt it a second time. Ultimately, if the ACH debit from your personal account fails, the business expecting the funds can hold you responsible for additional fees, such as late fees. If a bill continues to go unpaid, the company may send it to a collection agency, which will likely have a negative impact on your credit score.

How long does an ACH payment take to clear?

ACH payments are not immediate. In fact, they can take up to three or four business days. However, many banks have moved to next-day ACH transactions, which could mean funds are transferred in just one or two business days.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

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A bank guarantee is a promise by a financial institution that it will assume liability for a contract if one external party fails to uphold its obligation to another. In this way, the bank acts like a cosigner for a buyer or borrower on a business agreement, reducing the risk for the seller or lender.

For a small fee, bank guarantees often enable small businesses to enter into contracts with larger companies with which they otherwise would not be able to do business. In this article, we’ll explore:

•   How bank guarantees work

•   The different types of bank guarantees

•   The benefits and downsides of bank guarantees

•   How they differ from letters of credit.

What Is a Bank Guarantee?

Here’s what a bank guarantee is: It’s a financial instrument that adds confidence to riskier business deals. If, after doing its due diligence, a bank feels confident that an applicant (the debtor) will be able to uphold their contractual obligations, the bank will offer the guarantee to the other party (the beneficiary).

And if the applicant fails to fulfill that obligation to the beneficiary? The bank will cover the loss.

Bank guarantees are usually a part of more complex financial transactions between businesses. The average borrower won’t need to worry about bank guarantees for auto loans, mortgages, or personal loans.

Instead, companies utilize bank guarantees for much more complicated contracts around the provision of goods and services. If a vendor fails to provide goods or services that have already been paid for, a bank guarantee ensures reimbursement for the business using that vendor. Conversely, if a buyer fails to pay for goods or services that have already been delivered or rendered, the bank guarantee covers the unpaid balance for the seller.

Because a bank guarantee might protect a buyer or a seller, it’s easier to think of them in terms of the beneficiary (the company that requires a bank guarantee to move forward with a contract) and an applicant (the company that must apply for the bank guarantee to close the deal).

How Do Bank Guarantees Work?

If a contract includes a bank guarantee, that guarantee will specify an amount to be repaid (or goods or services to be delivered) and a set timeframe for that to happen. In addition, the contract will articulate the bank’s responsibility should the applicant fail to meet their contractual obligations.

To assume this risk, banks charge applicants a fee for the guarantee, expressed as a percentage of the cost or value of the transaction. While the fee will vary (perhaps from 0.5% to 2.5%), it is typically around 1%.

If the bank deems a contract particularly risky, it might require the applicant to offer collateral. Unlike with secured personal loans, where a house or car might serve as collateral, bank guarantee collateral is typically liquid assets, like stocks or bonds.

Types of Bank Guarantees

There are two main types of bank guarantees: financial bank guarantees and performance guarantees.

What Is a Financial Bank Guarantee?

With a financial bank guarantee, a bank has promised to repay a debt if the borrower (or buyer) defaults on the loan, meaning the payment. For example, an applicant may purchase goods and services from a large company, receive said goods and services, and never pay the bill. In this instance, the bank would settle the debt with the large company since it can’t come out of the borrower’s bank account.

What Is a Performance Guarantee?

A performance guarantee is just the opposite: If an applicant fails to perform the obligations laid out in contract (e.g., supplying parts to a company), the beneficiary can make a claim with the bank for the losses incurred from the non-performance of contractual obligations. Performance failure might also mean that, though the goods or services were delivered, they did not meet quality standards specified in the contract. In these situations, the bank would step in to offset those losses.

Examples of Bank Guarantees

Bank guarantees can serve many purposes, usually between two businesses. Here are a few kinds of guarantees that banks often issue:

Rental Guarantee

A rental guarantee protects a landlord when entering into a contract with a company (like a restaurant or retailer) that wants to lease a space. This guarantee serves as collateral for a rental lease.

Advanced Payment Guarantee

An advanced guarantee protects a company that has paid in advance for goods or services that weren’t delivered. You may also hear this referred to as a cash guarantee. If the deal isn’t satisfied, the company that has paid will be refunded.

Shipping Guarantee

A shipping guarantee protects a carrier when a shipment (i.e., import) arrives before required documentation. It is designed to smooth this kind of transaction when the documents have not yet become available.

Pros of a Bank Guarantee

When considering bank guarantees, you’ll see the term “beneficiary.” Don’t jump to conclusions about which party that might be. Bank guarantees can provide benefits for both the beneficiary and the applicant.

Benefits for the Beneficiary

First, let’s consider how a bank guarantee can help the beneficiary.

•   Reduced costs: A large, international company might save money in a specific region or country by doing business with a local vendor who does not have an international presence. By requiring that vendor to acquire a bank guarantee, the large company can feel confident about the decision while reducing costs.

•   Reduced risk: As mentioned above, the bank guarantee reduces the risk for the beneficiary. If the applicant fails to pay or to provide services or goods as outlined in the contract, the beneficiary can expect reimbursement from the bank.

Benefits for the Applicant

Now, here’s how a bank guarantee can benefit the applicant.

•   Increased opportunity: Bank guarantees let smaller companies and startups earn business they might not otherwise. Their newness in an industry might otherwise elicit hesitation from potential customers; a bank guarantee is often the boost needed to get business deals rolling.

•   Low cost option: All things considered, typical bank guarantee fees are low, especially when small business owners are used to dealing with higher interest rates (5.5% to 11.25%) on their small business loans, according to Experian, one of the major credit reporting agencies.

•   Credibility: Before offering a guarantee, a bank does a comprehensive, accurate assessment of an applicant’s financial standing. Earning a bank’s backing through a guarantee demonstrates that the bank finds the applicant company to be credible.

Cons of a Bank Guarantee

Both beneficiaries and applicants may encounter drawbacks to bank guarantees when initiating a contract.

Added complexity

First and foremost, a bank guarantee adds a layer of complexity to deal-making and may slow down business decisions. Companies operating in fast-paced markets may not be able to afford the delay.

Collateral requirement

If a venture seems particularly risky, banks may require collateral from applicants; this can be risky for startups with limited funding.

Lack of guarantee

Ultimately, a bank may not offer a guarantee, which means the beneficiary needs to be ready to continue its search for a new company to partner with.

Bank Guarantees vs Letters of Credit

Bank guarantees, as we’ve mentioned above, are typically used by companies bidding on large projects. The bank guarantee can underscore the business’ financial credibility. It provides assurance that a company has the financial means to complete the project in question.

Though they share some similarities with bank guarantees, letters of credit are more common in international trade. With a letter of credit, the bank is involved to a greater extent. Essentially, the bank releases the funds that the buyer owes the seller only when the seller has completed its contractual obligation (i.e., shipment has been received.)

Letters of credit instill confidence in sellers (exporters) that they will receive payment once they have shipped their goods. Likewise, importers only have to make payments (to their bank) after they have received the goods, so their funds aren’t tied up with no goods to show for it.

The Takeaway

A bank guarantee is a useful financial instrument that instills confidence between two external parties entering into a contract together. Such bank guarantees promise that the financial institution will cover any debts to one party if the other party does not meet its obligations. Larger companies often require small businesses and startups to obtain a bank guarantee before doing business with them. These guarantees can help a small or new business secure large deals since the bank has shown confidence in them.

If you want confidence in your bank for your personal accounts, consider SoFi. We help you bank smarter by offering you higher interest and no fees when you open our online bank account with direct deposit. You’ll earn a competitive APY while paying no monthly, minimum-balance, or overdraft charges.

Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.60% APY on SoFi Checking and Savings.

FAQ

What is the purpose of a bank guarantee?

The purpose of a bank guarantee is to add confidence to a contract between two parties; if one party fails to uphold its contractual obligations or defaults on a loan, the bank promises to step in and uphold the contract.

How can I get a bank guarantee?

If a business is requiring a bank guarantee to enter into a contract, contact your bank (or your business’ bank) and request an application. The bank will then review the application to determine your creditworthiness.

What are the types of bank guarantee?

There are two main types of bank guarantees: financial bank guarantees and performance guarantees. In a financial bank guarantee, the bank assures that a buyer will repay any debts owed to a seller. If the buyer does not, the bank will take on the debt. In a performance guarantee, the bank assures that the applicant will fulfill the tasks laid out in a contract. If the applicant does not, the bank will compensate the beneficiary to cover losses from the lack of contractual fulfillment.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.

SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

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A fiat currency is money that is issued and backed by a government, whereas cryptocurrencies are digital and are not issued by a government, bank, or other central authority. Examples of fiat currencies include the U.S. dollar, the euro, the yen, and most internationally traded currencies.

Fiat currency is considered centralized, because these traditional types of currency are typically governed by a single authority. Cryptocurrencies are generally decentralized, meaning they rely on blockchain technology and are overseen and managed by a distributed network of computers.

These days, it’s important for investors to understand how fiat money works, why it matters, and how it relates to different types of cryptocurrencies.

What Is Fiat Currency?

Fiat money evolved from asset-backed currencies, when governments would mint or print money that was either made from a physical commodity, i.e. precious metals like gold or silver — or could be redeemed for the equivalent amount of that commodity. Over time, though, it became impossible for governments to hold enough of a precious metal to back every coin or piece of paper currency, and so-called fiat currencies became common.

For example, the current fiat money system came about in the U.S. during the 20th century when many countries moved away from the gold standard, where currencies were directly tied to gold. Fiat money cannot be redeemed for an underlying asset, so its value is based on government policy and foreign currency markets.

There are currently some 180 fiat currencies in the world today. The value of fiat currencies is driven by the forces of supply and demand. Central banks like the Federal Reserve set monetary policy to control the supply, gauging how much money is needed in the economy and printing accordingly. The biggest risk is that they could print too much, triggering a bout of hyperinflation — rapid, out-of-control price increases that can lead to economic devastation.

Faith in a fiat currency hinges on the stability of the government that issues it, as well as trust in the central bank that manages its supply. Here’s a deeper dive into the fiat-currency systems that are fixtures of modern economies.

How Do Fiat Currencies Work?

Fiat comes from the Latin and generally means “a formal authorization; a decree.” So fiat money refers to an order by the government that gives these currencies value and makes them legal tender.

There is no underlying store of gold or silver to give fiat currencies material value.

Instead, fiat money is backed by the authority of each government. For example, the U.S. dollar is backed by the “full faith and credit of the U.S. government.” According to the Federal Reserve:

“(Dollars) are not redeemable in gold, silver or any other commodity, and receive no backing by anything. The notes have no value for themselves, but for what they will buy. In another sense, because they are legal tender, Federal Reserve notes are ‘backed’ by all the goods and services in the economy.”

Fiat money may be more susceptible to inflation and deflation because a government can print as much money as it wants. Also the value of these currencies rides on the confidence of consumers and the currency markets.

The Background of Fiat Money

Needless to say, the history of money is long and complicated. But the history of fiat currency is less so.

Essentially, for thousands of years goods were paid for by trading other goods (e.g. trading livestock for grain). During certain periods in the Roman Empire, salt was considered so valuable that people used that to purchase goods and pay people (that’s where the word “salary” comes from). Over time precious metals like gold and silver became a form of payment as well.

Asset-backed coins and paper money may have first emerged centuries ago in China. This representative money caught on because people could use it to pay for goods and services — and also redeem it for an underlying commodity. For example, currency in the United States was historically based on — and redeemable for — gold or silver. That ended in the Great Depression, when the Emergency Banking Act of 1933 stopped allowing citizens to redeem dollars.

The U.S. moved off the gold standard completely in 1971 for international transactions. And the dollar became a fiat currency. However, the Federal Reserve holds collateral that’s equal to the value of U.S. dollars in circulation in the form of government-issued debt.

Today, the Federal Reserve is required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt.

Alternatives to Fiat Currency

There are many alternatives to traditional fiat currencies, including something called “hyper-local currencies”, cryptocurrencies, and other tender created as a means of payment or exchange. Anyone, whether a company or individual, can create a form of tender (or payment) that can be used as an alternative to traditional currencies.

Alternative currencies don’t have to be regulated in order to function — all that’s required is for a group of people to agree to accept the alternate form of money as a store of value. For example, many businesses (e.g. airlines, credit cards) use systems of rewards and points that enable people to “earn” a kind of currency with that company that can be spent on other products.

What Are Hyper-Local Currencies?

Some areas of the world have independent forms of currency. In the Berkshires region, for example, there is a form of money called BerkShares, which is a way to stimulate the local economy. Similar examples exist in communities around the world, including in parts of England and Europe, where an alt currency was introduced to help support the local area.

Is Crypto an Alternative Currency?

Because most forms of crypto are highly volatile and can’t be used as actual payment for goods, services and other transactions, it’s an open question whether crypto can be considered a currency at all. Some forms of crypto are gaining traction as a form of payment, but the use cases are still somewhat rare.

Fiat vs Crypto: What’s the Difference?

Currencies basically serve two main purposes: as a medium of exchange and as a store of value. The rapid rise of investing in cryptocurrency has raised questions about whether fiat currencies will continue as the dominant medium of exchange.

Cryptocurrencies emerged almost a decade into the 2000s, with the launch of Bitcoin in 2009, the first and still the largest form of crypto. Cryptocurrencies are in essence virtual currencies that are part of the new DeFi, or decentralized finance, movement. They’re managed by a decentralized network rather than by a single authority, like government-issued fiat currencies.

Transactions made with cryptocurrencies are permanently logged on a ledger known as a blockchain. This ledger is viewable to anyone, therefore functioning as a public database. Because crypto transactions can be expensive, time-consuming, and complicated (to do business using crypto, you need a crypto wallet, for example) crypto may not be suited to real-world behaviors.

Fiat vs Crypto for Payment

Some proponents of cryptocurrencies argue that one day digital currencies will take over fiat money as the main mode of payment, because of their ability to deliver near-instantaneous transactions in some cases. They argue that if trust vested in a fiat currency is in the government backing it, trust vested in crypto is in the power of blockchain technology.

So far, though, cryptocurrencies haven’t really taken off as a medium of exchange. While some vendors and businesses accept crypto as payment, most transactions around the world are made with fiat currencies.

Critics argue that the volatility of cryptocurrencies like Bitcoin make them less ideal as a mode of payment. Imagine getting a paycheck in Bitcoin — such market fluctuations could dramatically magnify or shrink a person’s income in a matter of days.

Fiat vs Crypto as Store of Value

Cryptocurrencies like Bitcoin have arguably functioned more as a store of value, similar to how people have historically invested in precious metals.

Like precious metals, cryptocurrencies like Bitcoin need to be “mined,” which limits its supply. In fact, Bitcoin was designed with a cap on the number of coins that could be mined: 21 million.

Meanwhile, with fiat currencies like the U.S. dollar, the supply is potentially limitless. As of December 2020, there’s about $2 trillion or so of U.S. paper currency outstanding in the world. The Federal Reserve’s balance sheet— a proxy for the amount of money in the system — has grown by a staggering amount since 2007, as the central bank fought off recessions during the financial crisis of 2008 and the Covid-19 pandemic of 2020.

Meanwhile, speculators and investors have put money into the crypto market with the hope that their coins will maintain their worth or, ideally, increase significantly in value.

However, many others cite volatility as a reason why digital coins are not a reliable store of value.

What Are Central Bank Digital Currencies (CBDC)?

One potentially interesting development could be the advent of central bank digital currencies (CBDC) — virtual currencies that are created and backed by a nation’s central bank.

CBDCs sounds to some people like an oxymoron because cryptocurrencies by definition are decentralized and don’t have an authority backing them, but a January 2020 survey by the Bank of International Settlements found that 80% of central banks were researching and experimenting with CBDCs.

Fiat Currency	Cryptocurrency
Physical currency that’s issued and overseen by a central bank	Digital currency that’s created by a decentralized system
Can be used as a store of value	Too volatile to be a reliable store of value
Primarily used for real-world payments	Rarely used for real-world payments

Could Crypto Take Over Fiat Money?

Could cryptocurrencies become so ubiquitous that crypto would replace fiat currency? It’s hard to imagine, given the current state of crypto. Cryptocurrencies are still highly volatile and risky investments. In order for the vast majority of people to use crypto to pay for goods and services, there would have to be more stability in the crypto market.

Pros and Cons of Fiat Money

Pros of Fiat Money

A major convenience of paper currencies is that they are easy to produce, carry around, and consequently, good at facilitating exchange.

Another plus is not being reliant on a physical commodity market like gold. This means the money system isn’t as susceptible to the risk of outside players manipulating a metal’s supply and demand in order to distort currency prices.

Arguably, the most important advantage of fiat currencies is that they allow central banks to control money supply. Deciding how much currency to print is a valuable tool when trying to manage economic cycles.

For instance, the Federal Reserve has a dual mandate of keeping both unemployment and inflation low. In order to keep unemployment low, the central bank can boost currency supply, and when that starts to spark inflation, the Fed can raise interest rates to tame price increases.

Cons of Fiat Money

The biggest risk to a fiat-currency system is that the central bank miscalculates or mismanages and prints too much money — a situation that could result in hyperinflation, when the rate of inflation grows at more than 50% a month.

Fiat Currencies and Hyper Inflation

A 2012 study by the Cato Institute found that some of the worst cases of hyperinflation include Germany after World War I, from which there are photographs of German children playing with bundles of money as building blocks, and Zimbabwe from 2007 to 2008, when prices of bread skyrocketed and people carried cash in wheelbarrows.

Most recently, in 2019, hyperinflation in Venezuela reached 1,300,000%, pushing the government to issue 50,000 bolivar notes, which equaled $8.13 in U.S. dollars at the time.

Investing in Cryptocurrencies

A fiat currency is issued by a government, while cryptocurrencies are digital and rely on blockchain technology. Examples of fiat currencies include the U.S. dollar, the euro, the yen, and most internationally traded currencies. While there are fewer than 200 fiat currencies in the world, there are thousands of types of crypto: e.g. Bitcoin, Ethereum, Polkadot, Dogecoin, Litecoin, and more.

Fiat currencies by themselves have no intrinsic value. Instead, it is up to a government and its central bank to preserve their value, while also ensuring that there’s a healthy supply for an economy to grow. In a way, cryptocurrencies are similar in that they don’t possess inherent value, but investor demand means that some forms of crypto do have value and some are even used as payments.

While people argue that cryptocurrencies could challenge fiat as a store of value and medium of exchange, that possibility is a long way off. Cryptocurrencies like Bitcoin have seen their prices and popularity jump. However, they haven’t yet become a common way for people to pay for goods. Volatility in the market has also made some investors believe that digital coins aren’t a good store of value, although many investors have faith that crypto will grow.

FAQ

What are some examples of fiat currencies?

Most internationally traded currencies are fiat currencies: e.g. the U.S. dollar, the Japanese yen, the British pound, the EU’s euro, and so on.

Is Bitcoin considered a fiat currency?

No. Bitcoin is the oldest and still the largest form of cryptocurrency.

Why do they call it fiat money?

Because it’s backed by the authority of a governmental system (fiat means by an order or decree). It’s not tied to an underlying commodity such as gold or silver.

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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

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²Terms and conditions apply. Earn a bonus (as described below) when you open a new SoFi Digital Assets LLC account and buy at least $50 worth of any cryptocurrency within 7 days. The offer only applies to new crypto accounts, is limited to one per person, and expires on December 31, 2023. Once conditions are met and the account is opened, you will receive your bonus within 7 days. SoFi reserves the right to change or terminate the offer at any time without notice.

First Trade Amount		Bonus Payout
Low	High
$50	$99.99	$10
$100	$499.99	$15
$500	$4,999.99	$50
$5,000+		$100

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