Trade Finance: Readers' Q&A 2007
John Ahearn, Citi: This is a complex question that requires a very technical response.
There are many potentially problematic aspects to these transactions, so it’s very important for an institution to thoroughly understand the underlying transaction flows before getting involved. First, the deals may be structured to appear to be straightforward cross-border trade transactions. But at their core, they are in many cases actually working capital loans. If so, they may not – and it’s important to use the word ‘may’ because this hasn’t been legally tested – receive the same preferential treatment as trade transactions have traditionally enjoyed in case of an insolvency event for a particular country.
Let’s say COMCO, a fictional commodities company, has significant Brazil-China trade flow by exporting soybeans from Brazil and importing them to China. Most of this trade flow stays intra-COMCO. However, because soybeans are commodities – and it’s very difficult to squeeze additional margins on a commodity transaction – some very smart people at COMCO have figured out how, through financial engineering, to provide working capital below market by leveraging the trade flow.
For example – for a bank in China to borrow money on a working capital basis, the rate would typically be LIBOR plus 200. But to borrow on a trade transaction, the rate is LIBOR plus 150, a 50 basis point differential based on market history. If, because of a sovereign event, a country has to go to the Paris Club, trade transactions are always paid out before bonds or other obligations. Nations know that once trade flows are cut off and they can no longer import essential goods like petroleum, they’re dead. So, in this hypothetical example, COMCO says to the Chinese bank, “I can lend you my trade flow transaction of the soybeans I’m exporting to my operation in China. I’ll have you issue the letter of credit (LC) at 180-day terms, and give you cash collateral in US dollars. I will then discount your letter of credit with another financial institution, which will repay me my cash.”
In this scenario, COMCO gets cash out of the transaction, and a bank finances what it believes to be a trade transaction but really isn’t, since the soybean shipment is going COMCO-to-COMCO. The bank receives financing 50 basis points below what it would borrow on its clean line, of which it pays COMCO a few basis points. COMCO has now increased its return on the commodity shipments over what it would have received in a plain commodity deal.
While some banks recognize the potential risks in these transactions, others are buying them without sufficient due diligence and review. A genuine risk exists that a central bank or a regulatory authority might determine them to be artificially structured transactions, not trade deals, and cancel the preferential treatment. Also, certain countries maintain laws whereby the discounting bank may have violated offshore lending regulations by providing US dollar-denominated offshore financing for what was nominally a trade transaction but in reality was not. Instead, the bank is providing working capital lending for a domestic transaction for which it might not have a licence.
Finally, many of these transactions are structured so that the financing takes place in a country where the flow never came from. Hypothetically, a Russian bank, looking to take advantage of this financing, issues a letter of credit for a shipment going into Brazil, yet the goods themselves never touch the shore of the country where the LC was issued, possibly violating merchant banking regulations.
A financial institution considering entering into these types of transactions should clearly understand the risks involved, either accept or reject them, and then be sure that it’s getting adequately compensated. These transactions are often presented as very low risk – which I would say is true except in the event of economic turmoil, at which point they potentially could take on very high risk.
Ahearn: In many parts of the world, trade is moving from traditional commercial letters of credit to open account trade transactions, with a guarantee or standby letter of credit backing up the receivables. Banks without foreign branches themselves may want to approach one of their correspondents to issue a guarantee to the local supplier of goods to cover the accounts payable/accounts receivable.
As the market migrates to open account, however, some transactions are not really open account – they’re open account but with qualifications. For example, a supplier may say, “I’ll trade with you on an open account basis but I want your bank to give me a guarantee. I’m doing US$10,000 a month in trade with you, and the average terms are 30 days, but I want a guarantee for US$30,000 to cover what I’m shipping you today plus the last two shipments which may not have already matured.”
Another complicating factor is that a supplier may want a guarantee issued by a local bank in its home country – which has led to the concept of a bank issuing a guarantee or standby against another bank’s counter guarantee. For example, if I’m a US company bidding on a government project in Egypt, the country may not be willing to take a US bank’s LC because it’s from a foreign bank. The government doesn’t want that exposure, but it will accept an LC from an Egyptian bank. So my US bank approaches the Egyptian bank to say, “Here’s my counter guarantee. Please issue your guarantee for me based on the strength of my guarantee.” So it’s really a bank-to-bank transaction.
Ahearn: While the European Union may be establishing unification policies with regard to taxes and other matters, companies within the EU still operate independently. The procedures for establishing credit terms with a company there are the same as they are in the US. You could establish 15-day terms with one vendor and 180-day terms with another, both within the same country. Payment terms are based on what the market will bear and are a corporate decision, not a governmental or regulatory consideration.
Ahearn: The cost of technology for these types of systems has dramatically decreased in the last few years as technology has become more efficient. Another way of reducing costs is to consider companies that offer application service provider (ASP) models. A number of software vendors, as well as financial institutions, are willing to discuss ASP-type trade technology platforms.