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Some banks tout synthetic letters of credit (LCs) as a way of reducing risk, improving working capital and expanding credit lines in emerging markets. For others, fears around insolvency or fraud – and question marks over the underlying trade transaction itself – cause them to shy away.

“Synthetic LCs are like Marmite,” says Geoffrey Wynne, a partner at Sullivan and head of the law firm’s trade and export finance group. “In my experience, over many years of helping with them, parties either love them or hate them.”

Also referred to as structured or prepaid letters of credit, there is no universally accepted definition of a synthetic LC and examples can vary widely. Like a regular LC, they work by guaranteeing the seller will receive payment once their obligations are fulfilled, but differ in that they typically involve the bank issuing the LC receiving some or all of those funds upfront.

In practice, synthetic LCs tend to display other important characteristics. Speaking at an industry event in London this month, Paul Coles, head of market practice at the International Trade and Forfaiting Association (ITFA), said one such characteristic is that the banks and other participants “won’t always be in the usual jurisdictions”.

“The issuing bank is not necessarily going to be in the buyer’s jurisdiction, and the confirming negotiating bank is not necessarily going to be in the seller’s jurisdiction,” he said at a Northern European Regional Committee (NERC) educational seminar for ITFA members. “The trade flow won’t necessarily match with those jurisdictions.”

That disconnect is where much of the opportunity and risk lies for financial institutions.

Because cash is placed with the issuing bank upfront, synthetic LCs can act as a source of fresh deposits and a boost to working capital. For Coles, that has made them particularly appealing for financial institutions in emerging markets that may be “hungry for US dollars”.

For the confirming bank the transaction creates an opportunity to earn a fee, while the seller can be assured they will receive their funds or even request early payment at a discount. Trading entities can profit from the difference between the cash placed on deposit and the discounting rate, in effect creating an additional source of income on top of the trade itself.

 

When crisis hits

Despite those opportunities, synthetic LCs remain beyond some banks’ risk appetites.

Some of that is due to a perception that there is a higher risk of fraud. Jesuseun Fatoyinbo, head of trade at Nigerian lender Stanbic IBTC Bank, said at this month’s GTR West Africa event in Lagos: “There is a sense, in some way derived from the name of the product itself, that you might not be financing trade; there might be some funny stuff happening there.

“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.”

Coles, who is also head of global transactional distribution at HSBC but was speaking in an ITFA capacity, said banks can mitigate that risk by making sure they are “going in eyes wide open”.

“There must be an underlying trade,” he said. “The issue really is whether the structure is financing that underlying trade or whether that’s being financed from elsewhere. That will come down to different banks and different risk appetites.”

However, another concern is around what happens if the issuing bank is unexpectedly unable to fulfil its part of the transaction, for example due to insolvency, a country-level economic shock or a tightening of currency controls.

“In times of crisis, we tend to assume and believe that the government, the regulator, the banking sector as a whole, will give priority to trade obligations for the banks and try to settle those,” said Christian Karam, director of London-based investment advisor Africa Trade Finance, also speaking at the event in Lagos.

“We’ve seen it in Latin America and Eastern Europe, where trade is given a priority and without a haircut, because trade is the lifeline of the economy.”

The risk is if that trading activity has nothing to do with the country actually experiencing the crisis – Karam gave the example of an under-pressure Nigerian issuing bank using synthetic LCs to support trade between two other countries – banks have little way of knowing whether they can count on authorities’ support.

“If there is trade between one country and another that has nothing to do with Nigeria, there is a big question as to whether the regulator will use the foreign exchange of the country to allocate and pay for those obligations,” he said.

 

One-size-fits-all

Industry efforts are underway to improve understanding of the opportunities and risks presented by synthetic LCs, with ITFA recently establishing a working group to tackle the subject. The association says it is currently gathering information from the market and plans to issue a whitepaper within the coming months.

Crucially, the broad variation across the synthetic LC market means banks cannot take a one-size-fits-all approach.

“I’ve seen attempts at structuring things I don’t think ought to have been structured, and equally I’ve seen variations of plain vanilla transactions that look absolutely fine,” Sullivan’s Wynne tells GTR.

“It can be abused, but there’s nothing wrong with a well-structured synthetic LC. Ultimately parties need the right policies, the right transactions and the right documents. It’s a matter of understanding what you’re doing and documenting it properly.”