An influential industry group has issued first-of-its-kind guidance on structured letters of credit (LCs), a divisive product that is gaining popularity in the trade finance sector.

Structured LCs, also known as synthetic or prepaid LCs, vary widely but typically involve the issuing bank receiving upfront some or all of the funds due. The banks involved are often not in the same jurisdictions as the buyer and seller, with the transaction predominantly serving as a means to optimise liquidity.

As a trade finance instrument, structured LCs have been compared to Marmite. For some, they are a useful means of boosting liquidity for the issuing bank, allowing the confirming bank to earn a fee and the trader to generate additional returns – yet they lie beyond the risk appetite of other lenders.

In detailed guidance published on April 20, the International Trade and Forfaiting Association (ITFA) argues that structured LCs can be a valuable tool for injecting liquidity into emerging markets – but emphasises that to avoid risk, there should always be an underlying real-world trade transaction and all participants should be aware of the arrangement.

“These instruments have sometimes attracted controversy in part because of a lack of understanding of what they are and what they are seeking to achieve,” it says. “This guide attempts to provide clarity in this area whilst also pointing out the risks.”

Though there is no standardised definition of structured LCs, the association sets out several characteristics that typically separate them from traditional LCs.

The location of participants often differs from the actual route of transport, and the issuing bank is likely to be based in an emerging market where dollar liquidity is hard to come by.

Transaction values are generally high, with ITFA suggesting a typical range of US$5mn to US$50mn, while deferred payment terms of 180 or 364 days are common. Documents required to verify the trade can often be copies, rather than originals, and late shipment or “stale” documents may be acceptable.

“The goods are normally settled outside of the structured LC, but they employ the same trade flows, which makes it legitimate to issue a letter of credit,” says ITFA chairman Sean Edwards, speaking to GTR.

“It then effectively increases the financing period, for what would be the payment of the goods, giving a longer tenor, and that is then typically discounted by the confirming bank.

“There have been suggestions that structured LCs are questionable, that they are not transparent enough – we understand the criticisms, but as long as the banks know the details and everything remains transparent, there is nothing wrong with employing structured letters of credit. They have been a great tool for bringing liquidity to emerging markets for more than 20 years.”


Transparency and risk

If carried out correctly, the guidance says structured LCs can give issuing banks access to dollar liquidity and pricing, while generating a fee for the confirming bank.

“Financially sophisticated commodity traders often use structured LCs to enhance returns over and above their core physical trading businesses,” it adds.

“This usually takes place while a physical transaction is in transit on the high seas and before the underlying goods reach the destination port, where title documents pass to the end buyer.”

However, one concern around structured LCs has historically been that they operate in parallel to trade flows, primarily as a means of generating liquidity, rather than directly facilitating the movement of goods.

If there is an issue with the transaction – such as default or fraud – some market participants have expressed fear that outstanding payments will not be prioritised as they are not deemed by regulators or administrators to be true trade transactions.

“There’s been a record of some banks not honouring those obligations on LCs because in some way they believe that [trade] actually didn’t happen,” said Jesuseun Fatoyinbo, head of trade at Nigerian lender Stanbic IBTC Bank, at last year’s GTR West Africa event in Lagos.

The ITFA guidance says a review of case law from the US, China and Singapore suggests that traditional and structured LCs would generally not be treated differently.

However, a common theme is that all parties should be aware that the transaction is synthetic in nature, to avoid suggestions later on that some parties acted fraudulently.

Those cases suggest structured LCs “are likely to be enforced in the same way as traditional LCs, provided… that all parties in the transaction are aware and informed of its nature and purpose and that it supports a valid underlying trade transaction”, the association says.

If the bank is not directly involved in the main underlying trade, but is using it as the basis to generate a structured LC, that means it “needs to ensure that the trade really does exist”, Edwards notes.

“The way it does that is through copy documents,” he says. “There isn’t a standard form in the market for that, but most of the time the bank will be presented with copies of the usual documents that would support a trade settlement LC.”

The guidance also emphasises that the nature of the transaction should be consistent with the client’s business, that traders are considered experienced and trusted market participants, and that local regulations do not forbid the issuance of structured LCs.


Rising demand

Since starting work on the guidance over a year ago, ITFA’s Edwards says the appetite for structured LCs across the market appears to have grown.

“We’ve seen a lot of interest in the guide within the community, and more and more banks are offering structured LCs because it’s a convenient way of providing liquidity to those banks,” he says.

“That’s been important during the pandemic, when some of the more traditional funding sources have dried up, and with trade volumes reduced it became more important to optimise existing trade flows.”

The guidance points out that some banks participate in structured LCs “only with long-standing clients and under very specific conditions”.

“Once a decision is taken to proceed with structured LCs, the key mitigant is to know your customer and specifying under which circumstances you will participate in structured LCs,” it says.