ITFA, on the history and development of Structured Letters of Credit

SE: Structured LCs have emerged as a variant of Traditional LCs in the last 25 years. Their development came in three phases.

In the first phase, a large commodity trader was approached by its bank with a novel way to use the GSM-102 program offered by the Commodity Credit Corporation of the US Department of Agriculture (the “CCC”) which supported the export of US bulk agricultural products. 

The bank told the commodity trader that, instead of selling directly to the foreign buyer, it should set up a subsidiary in countries where it had large bulk sales and sell to it, thereby allowing the subsidiary to be the applicant on the CCC LC. The credit on the LC application was covered by a commodity trade standby letter of credit. Since the subsidiary would not need a loan from the foreign bank it could immediately prepay its obligation from the proceeds of the sight sale to the end buyer at a discount. The commodity trader could use the discount (basically a fee charged to the Issuing Bank for access to cheap funding under the CCC program) as a way to buy down the cost basis on the underlying commodities. In most cases, this allowed the commodity trader to offer more competitive pricing and thus gain market share. They used to refer to it as a “margin stretcher”.

This structure also established the two basic steps in almost all structured transactions: to sell on a term basis to an entity (usually a related party) to set up the debt obligation and then prepay that obligation at a discount with the proceeds of the sight sale.

In the 1990s, commodity traders started to adapt this CCC structure to commodity exports in a variety of geographical areas.

The next structure created was called a Corporate Transit Trade and placed a company in the middle of an existing trading pattern to obtain working capital financing. A commodity trader would sell to a company on 180-day terms which would either sell it back to the commodity trader or on-sell to a related party at sight. These were done while the goods from the original transaction were in transit on the high seas. These were then sold to banks as trade transactions related to the commodity trader under silent funded participation.

SE: Phase Two came in the late nineties, where it became apparent to other commodity traders that at least one of their competitors had some “secret sauce” that allowed it to under-bid the market for its commodity sales and win additional market share. The commodity trader was using its “margin stretcher” strategy to subsidise the cost basis of the underlying commodity sales. The concept of such structures spread to other commodity traders.

SE: In the third phase, trade finance expertise spread, and evolved around the three basic elements namely (i) Origination, (ii) Structuring and (iii) Distribution. Origination identified the entities that required financing; Structuring took care of the details of the transactions, and Distribution laid off the risk into the market and ensured a profit. With these three elements in place, they then needed flows of bulk commodities to complete such transactions.

The basic structures outlined above were used as they were familiar to both origination (borrowers) and distribution (discounting banks). Traders would first contract with a commodity provider to buy and immediately sell back a cargo that was in transit on the high seas. No principal needed to change hands with the contract amounts netting out and the difference between them amounting to a fee paid to the supplier for the use of the flow. While this was being negotiated, the Trader could arrange for an LC opening line of credit with a bank needing financing by way of posting cash collateral in the form of an interest-bearing deposit which would be equal to and cancel the term LC obligation at maturity. Knowing their costs and profit potential they could then arrange to pre-sell the transaction to a discounting bank to lock in a profit. Such transactions do not, however, represent the bulk of the current market.

SE: Structured LC business combines the financing of a real flow of commodities using the instrument of deferred payment LCs with the purpose of providing funding to financial institutions (importers’ bank / LC Issuing Bank) in mainly emerging markets and realising a benefit from other arbitrage (FX / interest rates) for traders.

There are three key counterparties participating in Structured LCs: the trader, the issuing bank and the confirming and discounting bank. Each has their own clear commercial motives associated with their roles in the transaction which enhance their economic position through their use of such instruments.

SE: Following the publication of the Guide in April 2021, the wording of section 5.2 has been amended to clarify the case law analysis referring to the position in China. The previous wording might have been misleading in appearing to suggest that courts in China would adopt a different position compared to other courts that have heard cases involving Structured LCs. ITFA has no reason to believe that the position in China would be any different to the other jurisdictions.

In summary, the analysis suggests that a Structured LC transaction should be documented in line with UCP600. It should be clear that all parties involved in the transaction are aware and informed of its nature and purpose and that there is an underlying trade transaction (which can be between companies in the same group). Cases make it clear that fraudulent transactions would not be upheld.