Demystification of structured L/Cs

TRF News talks to Sean Edwards (pictured), ITFA Chair and member of the ITFA Market Practice Committee, about the recent issued ‘Guide on structured letters of credit’ (L/C).

TRF News: What is a structured L/C and where did it evolve from?

Sean Edwards: Structured L/Cs first came about in the mid-80s based on a guarantee scheme made available by the Commodity Credit Corporation of the US Department of Agriculture to support the export of bulk agricultural products from the US. Commodity traders would establish subsidiaries in the countries they were exporting to, and in turn those subsidiaries would become the applicant for L/Cs issued by local banks and guaranteed by the scheme.

According to the guide: “After entering into a sales contract with an end buyer, the commodity trader will sell those same goods in a financial transaction, usually with a related party which is the financial buyer. The financial buyer applies for a deferred payment L/C with a bank seeking financing.

In order to obtain cash upfront the commodity trader discounts the L/C with its line bank and forwards the funds to the applicant who uses the proceeds to prepay its deferred payment L/C obligation at a discount. The difference between money earned on funding the bank and the discounted proceeds is the financial gain. The net result is that the discounting bank indirectly finances the L/C issuing bank and the commodity trader receives a fee for facilitating the transaction”.

TRF News: Are there any benefits to structured L/Cs in comparison to traditional ones, and who typically uses them?

Sean Edwards: Structured L/Cs meet a different need compared to traditional L/Cs, whilst sharing many common features. Traditional L/Cs facilitate the import and export of goods by reducing the risk of non-payment for the exporter and ensuring that the importer is paying for the right thing. On the other hand, structured L/Cs use the same basic structure but are enabling the three key parties to benefit from the transaction, namely commodity traders, issuing banks and confirming/discounting banks. The benefits are made available through the financing, which is not always a feature of a traditional L/C.

TRF News: How is financing provided through the use of structured L/Cs?

Sean Edwards: The financing of structured L/Cs is ultimately provided by the confirming/discounting bank, that discounts the deferred payment under the L/C. This financing is ultimately being provided to the L/C issuing bank, which benefits from foreign currency (typically USD or EUR) for the tenor of the deferred payment period. The commodity trader benefits from the extra income it earns from the differential between the cash it placed on deposit with the Issuing Bank and the discounted proceeds it receives from the confirming/discounting bank. The confirming/discounting bank also benefits through the margin earned by discounting the L/C.

TRF News: How do you see the use of structured L/Cs evolving in the next years, especially in comparison with traditional L/Cs and other means of trade financing such as open account-based structures?

Sean Edwards: It should be noted that there are already a number of different types of structured L/Cs. The guide has started with describing the most prevalent and ‘classic’ version, however others do exist and may be covered in updates to the guide in due course. It is therefore difficult to predict whether other iterations may be developed, however we can say that their continued use is likely as long as there are commodity flows and emerging market banks that require financing in foreign currency. Naturally, the guide may also enable more parties to understand how they operate and feel more comfortable using them as a result. It is harder to see how open account structures could meet the particular requirements that structured L/Cs address, although this could be an evolution to keep an eye on. An explicit purpose of the guide is to provide insight into the use of structured L/Cs and dispel the myths that inhibit their use. We see significant growth opportunities in Africa for example.