DEFINITION of Synthetic Letter of Credit
A synthetic letter of credit is a letter of credit that a bank has pre-funded on the closing date, instead of when the funds are drawn as needed. Banks will typically hold funds accessible through a synthetic letter of credit in a credit-linked deposit account until required.
BREAKING DOWN Synthetic Letter of Credit
Since the funds borrowed through a synthetic letter of credit are given immediately, they are a more liquid source of funds to the borrower than a standard letter of credit. Many consider the proceeds, therefore, to be more secure, as no counterparty risk exists. This could result in the funds becoming unavailable.
Synthetic Letter of Credit and Additional Forms of Letters of Credit
A standard letter of credit is a form of negotiable instrument that guarantees a buyer's payment to a seller. The bank ensures the seller will receive the funds on time and in the correct amount. A bank will cover the full or remaining amount for the seller if the buyer is unable to complete the purchase. For example, a large international bank may offer letters of credit for buyers in markets outside of the U.S., who may have difficulty obtaining international credit on their own. The established bank’s letters of credit can help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.
Several other forms of letters of credit exist, including a commercial letter of credit, standby letter of credit, revolving letter of credit, and confirmed letter of credit. These are just a few examples of numerous types of letters of credit that exist.
A commercial letter of credit is a direct payment method. In this instance the bank that issues the commercial letter makes the payments to the beneficiary. In contrast, a standby letter of credit is a backup payment method in which a bank will only pay the beneficiary when the holder is unable.
A revolving letter of credit allows the customer make any number of draws within a specific time period. Expanding upon this, banks that issue travelers’ letters of credit guarantee that they will honor drafts that a customer might make at certain foreign banks.
A confirmed letter of credit involves a second bank guaranteeing the original letter of credit. The second bank or confirming bank is typically the seller’s bank. In the unlikely case that both the holder and the issuing bank default, the confirming bank ensures payment under the letter of credit. In international transactions, the issuing bank typically requests this arrangement.