SBLC / BG – Stand By Letter of Credit or Bank Guarantee
Who Are SBLC/BG Providers ? How Does One Find A Genuine Provider ?
Standby Letter of Credit or Bank Guarantee (SBLC/ BG) Providers are mostly active in the secondary and the tertiary markets. But how does one find a genuine/reliable Provider for SBLC/BG ? To understand who these Providers are and how they function, one must understand about what is called as Collateral Transfers in the financial world. Collateral Transfer is basically the provision of transferring assets from one party (the Provider) to another party (the Beneficiary) often in the form of a Bank Instrument (BG or SBLC). This occurs whereby the Provider agrees (through his Issuing Bank) to issue a “Demand Guarantee” to the Beneficiary in return for a “rental” or “return” generally known as the “Contract Fee”. The parties agree to enter into a Collateral Transfer Agreement (CTA) which governs the issuance of the guarantee.
A Provider for SBLC/BG would often be a collateral management firm, a hedge fund, a Finacial Holding Company (FHC), a non-bank commercial company, or private equity company. They are high net worth corporations or individuals who hold bank accounts at a bank which holds either large sums in cash deposits, bonds, or other form of security like crypto currency that can turn into legal tender. Basically, in most cases these are liquid assets at the immediate disposal of their owner. Whenever the occasion arises, a Provider instructs his bank to secure and encumber liquid assets/ cash in his own account and authorizes the bank to “cut” (an industry term meaning to create a financial instrument such as SBLC or BG.
Provider’s bank has neither interest nor unsecured liability in such a transaction. The bank receives its fee for “cutting” (creating) the SBLC/BG and “delivering” it to the Receiver/Beneficiary’s bank first digitally over the SWIFT Platform and subsequently a hard copy of the SBLC/BG via bank bonded courier. All liabilities that might arise from selling or leasing the SBLC/BG rests completely with the Provider since the financial instrument (SBLC/BG) was created at the Provider’s instruction alone and also since it is secured against Provider’s cash/ liquid assets held by the bank. Provider’s bank that creates and delivers the SBLC/BG is called the Issuing Bank.
SBLC/BG Providers are a rare breed and are extremely difficult to find. Providers do not advertise themselves or send emails soliciting business from clients. As mentioned earlier, they are high net-worth corporations or individuals or funds and they hold a commanding position in the financial sector. Their businesses span across finance, banking, capital markets, oil & gas, commodities trading, manufacturing, IT, etc. More often than not, dealing in Financial Instruments is only a small portion of their business interests.
Providers of SBLC/BG generally work through their brokers or mandates who further engage sub-brokers in the chain making direct access to Providers even more difficult. It is absolutely futile to look for SBLC/BG Providers over the Internet. For those who work in the Financial Services sector and interact closely with high net worth individuals, private equities, funds, asset managers, banks, etc. on a regular basis, the chances of coming across a genuine SBLC/BG Provider is much higher than those who are outside the Financial Services sector.
- All SBLC/BG are a Physical Asset, Crypto Asset or Cash backed. A newly created SBLC/BG is called “Fresh Cut” whereas an already existing SBLC/BG is called “Seasoned”
- Whether purchased of leased, SBLC / BG is issued for a “term” having validity normally for 1 year and 1 day which may extend up to multiple years depending on the Provider’s own discretion and Provider’s level of comfort with the Beneficiary.
- Most banks will issue an SBLC/BG to any of its customers if they have sufficient (100% of Face Value of the Instrument) liquidity (cash) in their bank account or available balance in their credit line (if they are already availing a credit line from the bank). It’s a complete myth that “Banks Do Not Issue SBLC/BG). This direct transaction between a client and his bank is the “Primary Market” transaction.
- Providers of SBLC/BG generally are a part of the “Secondary Market” transactions. SBLC/BG Providers are high net worth corporations or individuals who hold bank accounts at the issuing bank that contain significant cash sums (assets). SBLC/BG Provider would often be a collateral management firm, a hedge fund, or private equity company. SBLC/BG Provider instructs its issuing bank to secure and encumber cash in his own account and authorizes the bank to “cut” (an industry terms meaning to create a financial instrument such as SBLC/BG ). Effectively, the SBLC/BG is “leased” or “sold” to the Beneficiary as a form of investment since the Provider receives a return on his commitment.
- SBLC/BG is issued under MT999, MT799, MT102, MT103 and ICC/URDG 758 (UPC 600) protocol and is readily accepted by almost all International as well as Private Banks.
- SBLC/BG is issued by the Issuing Bank of the Provider to the Beneficiary’s bank account at the Receiving Bank and is transmitted inter-bank via the appropriate SWIFT platform alone (MT-760).
- The Provider and the Beneficiary agree to enter into a Collateral Transfer Agreement (CTA) which governs the issuance of the SBLC/BG. The SBLC/BG is specifically issued to the Beneficiary for a defined purpose and each contract is bespoke. It is effectively a form of “Securities Lending” and often a derivative of “re-hypothecation”. The fact that there is an underlying agreement (the CTA) has no bearing on the wording or construction of the Guarantee (SBLC/BG). This allows the Beneficiary to use the SBLC/BG to raise credit, to guarantee credit lines and loans or to enter trade positions or buy/sell contracts.
- SBLC/BG is valuable in the secondary and tertiary markets, and this also creates an environment for Intermediaries to profit on the leasing and selling of SBLC/BG. Unfortunately, this also creates misunderstandings and opportunities for fraud. Scammers keep trying, by imposing their “procedures” which in general, involve rushed deals with no hard copies to follow, advanced payments, and so on.
- By its own nature and definition, only banks can legally issue SBLC (Stand-By Letters of Credit) or BG (Bank Guarantee). This is not only common sense, but actually regulated by banking laws in most countries since these are debt obligations issued by banks.
- SBLC/BG must be UCP-600 compliant and hence it must be issued by a licensed bank alone. Otherwise, it will not be UCP-600 compliant, regardless of the wording of the document. If it is not UCP-600 compliant, no bank will ever accept it as collateral or even as a documentary credit. While it is true that URDG-758 changed this from banks to “a bank, other institution or person” may act as a guarantor, the fact is that URDG-758 rules implied that financial stability of the guarantor is obligatory, and that the issuance of said documents shall be governed by the internal legislation of each country. Regardless, most banks will only accept documentary credit from other banks, due to their financial stability and their full compliance with local laws.
- Banks, in general, will monetize only an “owned/purchased” SBLC/BG. They will not monetize a “leased” SBLC/BG. In contrast to a purchased or owned SBLC where the buyer becomes the official owner of the instrument and in turn would be able to lease the SBLC out to a Third Party, a “leased SBLC” cannot be “leased out” any further.
- There are private Monetizers who would monetize a “leased” SBLC/BG. Some Monetizers will, however, only accept SBLC/BG with CUSIP or ISIN Numbers. This means they will NOT accept a fresh cut bank guarantee, ONLY seasoned instruments. Seasoned BG’s cost more and generally are only available to be purchased from secondary owners not banks.
- Although a leased SBLC/BG is not considered an “asset” (a leased SBLC/BG is not trading securities, trading debt instruments, or trading investment funds. There is no public market for the trading of SBLC/BG. All SBLC/BG transactions are private transactions), it can still be monetized, discounted or funded (whereby the SBLC/BG is turned into usable cash) by a resourceful Monetizer. Remember, SBLC/BG is after all a written obligation of the issuing bank to pay a sum on to a beneficiary on behalf of their customer in the event that the customer himself does not pay the beneficiary. The Instrument/ Security remains valid during the term before the Expiry Date. Such resourceful Monetizers possess the capacity to a draw a line of credit against “leased” SBLC/BG and use part of the cash to pay the client his “Non Recourse Monetization Payment” (often 40% to 65% of the value of the Leased Bank Instrument known as “Loan To Value” (LTV). The Monetizer then takes the balance of the money from the Line of Credit and places these funds into Trade / PPP using a proprietary trading platform. This platform is often a group of experienced bank traders who use the Monetizers cash and trade it generating significant profit returns on a weekly or monthly basis. Often the Platform uses normal trading risk protection strategies to ensure the Monetizers funds receive significant protection from all trading downside risk.
- Most people often confuse the term NOT RATED with the fact that some SBLC/BG issuing entities are not real banks, but private companies offering consulting services, and sometimes, issuing documents that are beyond their legal and financial capacity, hiding themselves behind the excuse that because they are an “offshore bank” or a foreign corporation or because they only deal with foreigners, they do not need to hold a banking license or comply with reserve deposits with the Central Banks of the jurisdictions from where they operate. The reality is, a rating is just an opinion given by one person or company, about the credibility of the bank or institution what the rating is about; but this has almost nothing to do with the truth, that the documents in question are worthless not because of the credit rating of the issuer, but because the issuer is not a bank.
- For political reasons, most Eurozone regulated banks avoid, as much as they can, to work with banks of certain countries. Trying to monetize an instrument issued by a Latin American country, or even China is almost impossible!! Even Europe is not free of that problem; for example, while the list of embargo banks from Russia and Ukraine is very small, most Eurozone regulated banks prefer to not accept as collateral instruments issued by any Russian or Ukraine based banks, they say it is to reduce their risks as much as possible, and to avoid working with banks that while not currently on the embargo list, can be included in said list at any time. Some other countries have strong, reliable and highly praised banks with excellent credit ratings, like Azerbaijan, yet almost no Eurozone regulated bank wants to work with instruments issued by them; this limits the ability of most monetizers to work with instruments from banks of these countries regardless of the credit rating of the bank.
- To determine if a borrower is worthy of an SBLC/BG, many banks will undertake a credit analysis. Credit analyses focus on the ability of the organization to meet its debt obligations, focusing on default risk. Lenders will generally work through the five C’s to determine credit risk: the applicant’s credit history, capacity to repay, its’ capital, the loan’s conditions, and associated collateral. This form of due diligence can revolve around liquidity and solvency ratios. Liquidity measures the ease with which an individual or company can meet its financial obligations with the current assets available to them, while solvency measures its ability to repay long-term debts. Specific liquidity ratios a credit analyst may use to determine short-term vitality are current ratio, quick ratio or acid test, and cash ratio. Solvency ratios might entail the interest coverage ratio.
- SBLC/BG denotes an irrevocable obligations assumed by banks. The principle that if a compliant demand is made under a standby letter of credit, an issuing bank must pay, subject to only very limited exceptions.
- A key purpose of the widespread use of standby letters of credit to finance commodity transactions is the comfort it gives to the seller that it will receive payment.
- The drafting of the SBLC/BG should provide that the presentation of a demand would be conclusive evidence that the amount claimed was “due and owing” to the Beneficiary of the SBLC/BG. The beneficiary’s belief that payment was “due and owing” should activate payment.
- The meaning of the words “obligated to pay” has to be considered in the context of the certificate to be tendered under the SBLC/BG.
- Exceptions to the rule that an issuing bank must pay under an SBLC/BG are limited and difficult to prove. If you have concerns about the reliability of your counterparty, requiring them to provide an SBLC from a reliable bank and governed particularly by English law remains a good way of securing payment.
- If you are the beneficiary of an SBLC/BG, you should insist that it contains clear wording to the effect that presentation of a demand by you will be conclusive evidence that the amount claimed will be “due and owing”. In order to rely on the strength of these decisions, you should also ensure that English law governs the SBLC/BG, even if it does not govern the underlying contract.
- The great utility of the standby letter of credit is reflected in the fact that it can be used in practically any situation in which one party to a contract is concerned with the other party’s ability to perform. Some of the many ways in which a standby letter of credit can be used are: to ensure payment or performance in construction financing, corporate consolidations, real estate transactions, management contracts, leases on real and personal property, stock transfers and purchases, and bid and performance bonds; to ensure payment of salaries to highly paid individuals such as professional athletes and entertainers; and to ensure payment of professional services such as attorney’s fees.
- The standby letter of credit is neither a contract nor a negotiable instrument and if it is not properly drafted, it will not be considered a guarantee at all. The standby letter of credit or SBLC/BG is a distinct legal instrument, unlike any other. The obligation of the issuer of the SBLC/BG is independent of the underlying contract between the issuer’s customer and the beneficiary of the SBLC. The standby letter of credit enables a businessman to enter into business ventures with minimal fear of loss. By substituting the credit of a third party, usually a bank, for that of the debtor, the businessman can help to protect his investment. Finally, the standby letter of credit is particularly well suited for preventing loss or delay of payment caused by the debtor’s bankruptcy. Because the standby letter of credit and its proceeds are not part of the bankruptcy estate, the beneficiary of a standby letter of credit should receive payment from the bank without delay. The low cost and adaptability to a wide range of business transactions make the standby letter of credit very attractive to the business community and to business lawyers.
- Standby letters of credit frequently involve negotiated, complex agreements and larger dollar amounts where lawyers tend to be more involved. Examples include standbys supporting or securing municipal bond issues, construction contracts, subdivision and municipal improvements, commercial real estate leases, equipment leases, cable installations, reinsurance requirements of nonadmitted reinsurers, power purchase contracts, SWAP agreements, securitizations, self-insured retention amounts in insurance fronting arrangements, indemnification obligations for surety bonds, supersedeas bonds to stay execution of a judgment pending an appeal, prejudgment attachments bonds, government contracts or privileges, clearing obligations of brokers and dealers, advance payment guarantees, and open account sales.
- Commercial letter of credit customs and practice carry over and are applied to standby letters of credit because standby letters of credit evolved from and have many characteristics in common with commercial letters of credit. Commercial letter of credit customs and practice were established well before standby letters of credit gained usage and popularity. Until 1998, when the International Standby Practices or “ISP”5 was promulgated, almost all letters of credit were issued subject to the Uniform Customs and Practice for Documentary Credits (the UCP).The UCP is specifically geared to examining documents presented in international trade such as drafts, bills of lading, other types of shipping documents, insurance certificates, inspection certificates, commercial invoices, and packing lists. The UCP also provides for the “negotiation” of drafts and documents presented to banks other than issuers that are “nominated” in letters of credit to purchase and present the drafts and documents. Both of these situations—live commercial documents and negotiation of drafts and documents—are seldom relevant to or found in standby letter of credit practice.
- The UCP governs standby letters of credit to the extent that its articles are applicable.The UCP does not explain when and how its articles should be applied to standby letters of credit.Even preparing a draft to be presented under a standby letter of credit can present challenges for those who do not have a working knowledge of how banks expect drafts to be worded and presented. Yet every regime that governs letters of credit provides that standard banking practices or international standard banking practices are to be used to determine whether documentary presentations and other aspects of letter of credit transactions are proper and compliant.
- Much of the lack of familiarity with or transparency of standby letter of credit practices has been overcome by the International Standby Practices, or ISP. The ISP’s rules specifically address standby letter of credit practice separate and apart from commercial letter of credit practice. The ISP’s rules are well written and for the most part are clear, even-handed, and straightforward. They avoid significant pitfalls of using the UCP in standby letters of credit, such as presentation of stale documents, installment drawings, force majeure, and the requirement that documents and data in documents be consistent. Unfortunately, the UCP is still used in almost half of the standby letters of credit issued in this country and probably in more than half issued by foreign banks in other countries. Additionally, even the ISP’s rules are not all-encompassing. Resort to standard banking practices outside the ISP, caselaw, and the UCC is necessary to fill in the gaps. Finally, there are several rules or provisions of the ISP, the UCP or the UCC that govern standby letters of credit that lawyers and their letter of credit applicant or beneficiary clients may not be familiar with, overlook, or miscomprehend their import. Many letter of credit customs, practices and rules are counter-intuitive and cannot be predicted by resort to simple contract law principles or even other articles of the UCC.1
What is a standby letter of credit? Also referred to as an SLC or LC (letter of credit), these are obligations issued by a bank in written form, the purpose of which is to promise payoff of a certain sum of money to a beneficiary. These obligations are issued on behalf of the customer in case he or she does not pay for a service or product provided by the beneficiary.
In the following arrangement, a bank provides payment backup in the case of unpredicted situations in which the customer fails to pay for a service they have received. The bank then appears as an independent third party that does not hold interest. The issuance of standby letters of credit is considered a private transaction, the process of which isn’t related to any public trading security issuance.
The use of standby letters of credit is advantageous for beneficiaries, as they ensure:
- getting paid under any circumstances
- Completion of a product or service on time
- that all agreement terms are complied with
As a result, even if a customer fails to pay for a provided service, the bank does it for him or her, and is responsible for reimbursing the recipient’s funds.
There also exist a number of standby letters of credit, and their type depends upon a range of factors.
|Performance Standby||This instrument supports an obligation to perform (other than paying money), and includes covering losses arising from default of the applicant in the completion of an underlying transaction.|
|Advance Payment Standby||This instrument supports an obligation to account for an advance payment made by the beneficiary to the applicant.|
|Bid Bond/Tender Standby||This standby supports an obligation of the applicant to execute a contract if the applicant is awarded a bid.|
|Counter Standby||This instrument supports the issuance of a separate standby or another undertaking by the beneficiary of the counter standby.|
|Direct-Pay Standby||This instrument serves to support payment when due of an underlying payment obligation, typically in connection with a financial standby without regard to default. This standby is also used to directly pay an obligation where the only conditions of payment are the passage of the term and presentment of payment.|
|Insurance Standby||This instrument is an insurance or reinsurance obligation of the applicant.|
|Commercial Standby||This is the most-used standby, and it supports the obligation of an applicant to pay for goods or services in the event of non-payment by a business debtor.|
The general idea of standby letters of credit is advantageous and useful. However, it should be stated that the process of receiving such obligations is very complex, as it involves numerous parties and takes approximately 60 days to be confirmed.
First, let’s take a look at a simple example in order to understand the exact situations in which standby letters of credit can be applied.
- Let’s say a customer and a provider want to settle a deal. The customer can request certain products from the provider; or perhaps the provider promises to conduct a certain service (like building a pool in the customer’s yard).
- The provider questions the fact that the customer will pay on time, and in order to eliminate this risk, asks him or her to provide a standby letter of credit.
- The customer goes to the bank and requests the SLC. If the documentation is fine, he or she receives the obligation.
- The provider reviews the SLC in order to ensure that it is acceptable, and makes a decision whether or not to proceed with the arrangement.
- In case the customer fails to comply with the set conditions and obligations, the provider receives his or her funds from the bank that issued the standby letter of credit.
In order for a customer to have his or her SCL approved, there are a number of steps to go through. The process involves numerous parties. Have a look at this list of the individuals involved in standby letter of credit issuance:
In industry, the process of financial link automation between trade finance and cash flow is very complex, as we have mentioned above. The graphic below illustrates the traditional flow of this process:
Therefore, the complexity of standby letter of credit issuance results in:
- operational inefficiencies (manual and paperwork, time consumption, lack of standardization)
- working capital (balance-sheet implications)
- lack of visibility (not knowing holistic exposures)
Blockchain as a Solution to Trade Finance Complexity
Blockchain is a new distributed ledger technology that has been applied in all types of industries in order to correct workflow inefficiencies. It is one of the best solutions for cutting down on paperwork, eliminating third-party involvement, establishing safe and transparent data storage, and providing security in transaction processing via smart-contract use.
The financial industry benefits from blockchain applications in numerous ways. As a result, 77% of companies (respondents) are ready to implement it, according to FinTech research.
“With blockchain implementation, the trade finance industry can easily establish transparent and secure communication via the decentralized ledger, and deals can be executed much faster than traditionally. Automated execution is enabled via smart-contract use, and ensures that all participants adhere to a set of predefined requirements. Moreover, all relevant information concerning trade procedures, participant data, and transaction processing can be all viewed and easily accessed, providing a higher level of trust and transparency,” states Stanislav Sheliakin, Applicature business analyst.
Blockchain Applications for Letter-of-Credit Issuance
As we discussed earlier, the process of SCL issuance is complex, and faces such issues as time consumption, excessive manual work, and lack of transparency. To solve these issues, banks have become more interested in blockchain technology implementation, as it is capable of solving all of them. An innovative factor in the financial industry is the fact that an immutable record entered into the blockchain once can serve as a means of verification and prevent any data forgery.
When applied to the process of SCL issuance, blockchain contributes by:
- streamlining documentation processing via automation or use of AI
- enhancing security by reducing human-error factors and providing privacy with encryption
- predicting working capital and providing accessible information through via user interface or mobile application
Blockchain’s advantageous properties also provide the following solutions:
- Documentary fraud elimination (due to the features of transparency and consensus-reaching)
- Product authenticity (due to traceability and transparency)
- Secure value delivery and transaction processing (via immutable record storage and digital signature uniqueness)
- Privacy between participants (due to cryptography and the use of private or consortium ledgers)
- Flexibility and robustness (due to blockchain’s decentralized nature)
- Cutting on the downtime and delays (due to automated deal execution via smart contracts)
- The ability to move various assets while tracking and purchasing them at the same time (with IoT application).
Considering its list of pros, many companies have turned to blockchain integration. Here are several examples to consider:
Microsoft. Microsoft treasury and Microsoft blockchain-as-a-service have worked with the Bank of America to automate the standby letter of credit procedure. With blockchain integration, they used proof of concept (POC) consensus and managed to enhance their:
- speed and efficiency of execution
- real-time data and audit tracking
- transparency and trust between users
As a result, the process of SLC issuance was simplified, and could be conducted in 40 minutes instead of months:
BBVA. This company used blockchain technology from Wave, and managed to cut international trade processing time (submitting, verification, and authorization) from a week to just two to three hours.
“The operation was registered and securely validated at the same time for all parties, thanks to the distributed ledgers and the immutability of blockchain,” comments Daniel Berenguer, Head of Digital Trade at BBVA.
HSBC. This is the seventh-largest bank in the world. It recently issued an LC for the American food company Cargill via blockchain. As a result, with the use of the Corda blockchain platform, they managed to settle the deal in just 24 hours.
As a matter of fact, more and more financial trade companies are turning to blockchain, as it is especially convenient in terms of logistics and trade operations. The issuance of standby letters of credit within blockchain technology stands as a bright example of the technology’s functionality and utility.