What it means
A standard letter of credit is a promise by a bank to pay a seller if the buyer fails to do so, provided the seller presents the right documents. It lets strangers trade with confidence, particularly across borders.
The buyer usually pays a fee and may need to tie up cash or credit lines with the bank. Sometimes that route does not fit.
The buyer may lack the credit lines, the bank may not operate in the seller's country, or the deal may need terms that the standard product does not allow. In those cases parties build a substitute that delivers a similar promise.
Common building blocks include a guarantee from a parent company or insurer, a surety bond, cash held in a controlled account, and a credit-linked structure in which a financial institution agrees to pay if a named party defaults. Each gives the beneficiary a source of payment other than the buyer, which is the key feature of a letter of credit.
The legal wording decides whether the beneficiary can claim on demand or must prove a loss first. The cost and strength of a synthetic arrangement depend on who stands behind it.
A guarantee from a highly rated insurer is stronger than a promise from an unrated affiliate. Beneficiaries therefore look at the credit quality of the provider, the conditions for making a claim and the expiry date.
Because there is no single standard form, the term can mean different things in different contracts. Finance teams should insist on a clear description of the parties, the amount, how a claim is triggered and which law applies.
Where possible they should seek legal advice, as the protection is only as good as the document.
In practice
Real-world examples.
Example
A construction contractor needs to give a client a payment assurance but has used up its bank credit lines. It arranges a surety bond from an insurer to serve the same purpose.
Example
An importer buying machinery from a supplier in a risky market places cash in a controlled account that can only be released against shipping documents. The supplier treats this as equivalent to a letter of credit.
Example
A parent company issues a guarantee for the obligations of its new subsidiary, which has no credit history. The subsidiary's landlord accepts it in place of a bank letter of credit.
Formula
Calculation
Annual cost = Guaranteed amount x Fee rate
Suppose a buyer needs to give a supplier assurance of payment for $2,000,000, and an insurer will provide a guarantee for a fee of 1.5% a year.
Annual cost = $2,000,000 x 0.015 = $30,000
If the arrangement lasts 9 months, the cost is $30,000 x 9 / 12 = $22,500.
A bank letter of credit charging 2.0% would cost $2,000,000 x 0.02 = $40,000 a year, or $30,000 for 9 months, so the synthetic route saves $30,000 - $22,500 = $7,500 in this example, though the bank may also require cash collateral.Case study
Seen in the real world.
Westbrook Energy is an illustrative, fictional trading firm that needed to assure a supplier of payment for a $4,000,000 cargo. Its bank lines were full, and a new letter of credit would have taken two weeks to arrange.
The finance director instead offered a guarantee from an insurer with a strong credit rating, backed by a $400,000 deposit. The supplier's lawyers reviewed the wording, checked that the guarantee could be claimed on demand, and accepted it.
In the illustrative result the cargo shipped on time and Westbrook paid on the due date, so the guarantee was never called. The fee of 1.2% on $4,000,000 for three months came to about $12,000, and the director noted that the deal would have been lost if she had waited for a bank.
Watch out
Common mistakes.
- Assuming a synthetic letter of credit has the same legal force as a bank letter of credit, when the protection depends entirely on the document used.
- Ignoring the credit quality of the guarantor or insurer.
- Forgetting the expiry date, after which the beneficiary may be left without cover.
Questions
People also ask.
Is a synthetic letter of credit regulated like a bank letter of credit?
Not necessarily, since standard rules for documentary credits may not apply, so the contract wording is critical.
Why would a business use one?
To get payment assurance when bank facilities are full, too expensive or unavailable in the required form.
What should the beneficiary check?
The identity and strength of the provider, how and when a claim can be made, the amount and the expiry date.
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