Performance Bonds, Performance Bond
Performance bonds, or surety bonds, are financial tools that act as guarantees for the satisfactory completion of a project. These bonds are generally used in the construction and services industries. They are also used frequently in the financial trading markets. In trading markets, performance bonds signify a collateral deposit for securing a futures contract (margin). A performance bond is usually issued by a bank or an insurance company, both of which act as a “surety.”
How do Performance Bonds Work?
In the construction industry, a performance bond protects a project owner against possible losses in case a contractor is unable to deliver products/services as per the terms and conditions of the contract. In case the contractor defaults or declares bankruptcy, the surety is liable to compensate the owner for the losses. The monetary compensation is limited to the amountmentioned in the performance bond.
In the financial trading sector, a performance bond ensures that a clearinghouse recovers its money from a trader if s/he suffers losses in his/her trading position in futures. If the price of a futures contract bought by a trader varies, the clearinghouse debits or credits the value of the performance bond accordingly to ensure that its losses are covered. When the value of a performance bond falls below a certain level, the trader needs to deposit additional funds in the bond to revive its value.
Benefits of Performance Bonds
Performance bonds ensure that:
- The owner of a project (clearinghouse in case of the financial sector) is assured of the completion of the project.
- The owner (clearinghouse in case of the financial sector) does not need to incur additional costs.
Drawbacks of Performance Bonds
The drawbacks of performance bonds are:
- The owner (clearinghouse in case of the financial sector) needs to accurately quantify the losses that s/he might have suffered when a trader or contractor defaults. In case the owner underestimates the losses and the future cost of the completion of the project, s/he may not be able to recover the shortfall from the surety.
- At times, the surety tries to establish that the owner (clearinghouse in case of the financial sector) did not comply with the technical conditions of a bond to avoid paying the compensation. If the surety succeeds in proving this, the owner may have to settle for the least expensive remedy to the problem.