What Is a Synthetic Letter of Credit?
A synthetic letter of credit (SLC) is a pre-funded, negotiable instrument that guarantees a specified payment will be rendered. Letters of credit can be structured in a variety of ways. Broadly, the different types of letters of credit can be grouped into two categories: funded and unfunded.
- 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.
- SLCs are viewed as lower risk than regular letters of credit since they generally eliminate counterparty risk.
- All types of letters of credit are widely used in international trade. A seller may require a SLC because it has many risk management advantages over a standard, unfunded letter of credit.
Understanding Synthetic Letters of Credit
Letters of credit are most commonly provided as unfunded, negotiable instruments. These instruments provide backing from a bank, offering a second line of funding that helps to guarantee a buyer's payment to a seller. A synthetic letter of credit simulates a standard, unfunded line of credit but requires a deeper relationship with more complex provisions. The synthetic letter of credit is fully funded with money allotted to a specified account when the letter of credit is signed rather than exercised.
Synthetic letters of credit may also be known as fully funded documentary letters of credit. Establishing a fully funded letter of credit can potentially come with separate account fees or possibly some accumulating interest while the funds are held.
Comprehensively, letters of credit are widely used in international commerce. The type of letter of credit required will usually be dictated by the seller. Some sellers may accept unfunded letters of credit while others require a funded, synthetic letter of credit. 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 fully complete the purchase, the bank will cover the full or remaining amount.
Synthetic letters of credit offer an even greater level of liquidity and assurance because the funds have been pre-arranged by the bank. This helps to make the funds more immediately available. As a result, synthetic letters of credit effectively eliminate any counterparty risk for the seller in the transaction.
Synthetic letters of credit are widely used in international commerce to facilitate trade between importers, exporters, and intermediaries. Beyond just counterparty risk, other risks that SLCs help to mitigate can include currency risks, language barriers, and cross-border tax issues.
Obtaining a Letter of Credit
Large established businesses involved in international commerce globally will usually have a strong relationship with a financial institution that handles their letter of credit arrangements. All types of letters of credit are a form of lending. This requires a business to meet specified credit offering standards. As such, obtaining a letter of credit may involve a commercial credit inquiry and/or credit reporting.
Commercial credit scoring differs from individual credit scoring in that many large businesses are labeled with a corporate credit rating by the credit rating agencies. A developed relationship with a single letter of credit provider is typically best since the financial institution can potentially use a single account for managing any funded and unfunded letter of credit issuance.
Many large companies with multi-national operations will typically look to work with a large international bank that can facilitate fast and efficient processing in multiple countries. Synthetic letters of credit are particularly useful in this regard because the bank manages transaction activity and the funds are available for rendering immediately.
Different Types of Letters of Credit
Several different types of letters of credit and letter of credit provisions exist. Broadly, all types of letters of credit will be either funded or unfunded. Beyond that, letters of credit may also be labeled or structured as:
- Commercial letters of credit: Business has relationship with bank that makes direct payments to the seller.
- Standby letters of credit (SLOC): Only require the bank to pay the beneficiary/seller if the buyer obtaining the letter is unable to do so.
- Revolving letters of credit: Like a revolving line of credit. Permits a series of draws against a specified limit.
- Confirmed letters of credit: Provide an additional guarantee from a second bank. For those who want to further minimize counterparty risk.
- Revocable letter of credit: Changes can be made to the letter of credit terms at any time.
- Irrevocable letter of credit: No changes to the letter of credit terms can be made without the approval of all parties involved.
- Red clause letter of credit: Offers some amount of advance payment.
- Green clause letter of credit: Offers payment after a specified communication of warehousing.
Real World Example of a Synthetic Letter of Credit
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. A U.S. company who does a substantial amount of business in China for example, might want to work with a Chinese bank to manage their letter of credit agreements. By issuing letters of credit to U.S. companies, the Chinese bank can help its domestic importers to minimize country risks. This arrangement can also reduce credit risks and currency risks for the parties involved.