What Is a Synthetic Letter of Credit?

A synthetic letter of credit is a negotiable instrument that guarantees that a specified payment will be rendered. Unlike regular letters of credit which are funded by the bank on an as-needed basis, synthetic letters of credit are funded ahead of time.

Synthetic letters of credit are viewed as being lower risk than their regular counterparts, and are widely used in international trade.

Key Takeaways

  • 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.
  • They are viewed as lower risk than regular letters of credit, and they are used to reduce counterparty risk.
  • Synthetic letters of credit feature widely in international trade. In addition to counterparty risk, they can also be used to reduce currency and liquidity risks.

Understanding Synthetic Letters of Credit

A standard letter of credit is a form of negotiable instrument that guarantees a buyer's payment to a seller. By relying on letters of credit, sellers can ensure that they receive the buyer's funds on time and in the correct amount. If the buyer is unable to complete the purchase, the bank will cover the full or remaining amount. As such, these instruments are widely used in international commerce.

Synthetic letters of credit offer an even greater level of liquidity because the funds borrowed through them are pre-funded by the bank and thus available immediately. As a result, they effectively eliminate the counterparty risk associated with such transactions.

Synthetic letters of credit are widely used in international commerce to facilitate trade between importers, exporters, and their intermediaries. After all, international companies must deal with a variety of complications, including currency risks, language barriers, and cross-border tax issues. Oftentimes, an additional struggle that international companies face is counterparty risk, especially when they are doing business with companies in other legal jurisdictions.

International banks can help mitigate this counterparty risk by providing letters of credit to the companies involved. This prevents companies from having to deal directly with each other, instead of relying on the bank as a simple and dependable source of liquidity. Synthetic letters of credit are particularly useful in this regard, because the funds in question are rendered immediately, bypassing any potential delays.

Letters of Credit

Several other forms of letters of credit exist. For instance, commercial letters of credit involve the bank making direct payments to the beneficiary. By contrast, standby letters of credit (SLOC) only require the bank to pay the beneficiary if the purchaser of the letter is unable to do so. Revolving letters of credit permit a series of draws within a specified time period, while confirmed letters of credit provide an additional guarantee from a second bank, for those who want to further minimize counterparty risk.

Real World Example of a Synthetic Letter of Credit

For example, a large international bank may offer letters of credit for buyers in markets outside of their home country, given that these buyers might have difficulty obtaining international credit on their own. 

By issuing a letter of credit, the international bank can help its domestic importers by minimizing the country risk faced by the importers. This arrangement can also reduce credit risk and currency risk for the parties involved.