LC VIEWS

Voice of LC World
Newsletter No. 79, December 2006

Structured Trade Finance Revisited

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Jee Meng Chen clarifies and elaborates in his talk with LC VIEWS editor Ravi Mehta

STRUCTURED TRADE FINANCE

STF relies substantially on structuring techniques to mitigate idiosyncratic performance and transactional risk issues, with emphasis on the ring-fencing of cash flows (i.e., isolating predictable and/or future cash flows) from the transaction, to secure the credit.

In essence, there is nothing in trade finance that warrants structuring. It is about structuring deals, which are trade finance-focused. The suitability and feasibility of any proposed structure is circumstances-specific. Any attempt to achieve a one-size-fits-all approach can backfire

Ravi: When I was working in Indias banking system in 80s and 90s I never heard of structured trade financing. In Indias banking language at that time the only term was trade finance and no its any variant. So it is tempting to know the meaning of the modern concept of structured trade finance. Could you please tell us the meaning and how it differs from traditional concept of trade finance? Chen: There are many definitions of Structured Trade Finance and/or its
equivalent. Here, I would not attempt to explain, in-depth, the different variations. In fact, bankers are often confused, as financial institutions adopt different terminologies, alongside varying definitions. Worth highlighting, the differences in terminologies are necessary, at times, for purposes of (i) market segmentation and (ii) risk management. I have broadly amalgamated the definitions of structured trade / structured commodity financing into a singular explanation Structured Trade Financing (STF), as follows: STF relies substantially on structuring techniques to mitigate idiosyncratic performance and transactional risk issues, with emphasis on the ring-fencing of cash flows (i.e., isolating predictable and/or future cash flows) from the transaction, to secure the credit. [See Taxonomy of Structured Trade Finance, September / October 2006 edition of (LC Monitor)]. STF comprises four elements, namely, (1) Structuring Techniques, (2) Performance Risk, (3) Transactional Risk Issues and (4) Ring-fencing. While these four parameters may not be entirely comprehensive, I feel, they would have encompassed the essence of most variations of structured trade financing. To address the query, Could you please tell us the meaning and how it differs from traditional concept of trade finance? STF is structured lending; it is not trade financing, per se. STF requires the structurer to effectively as well as creatively apply trade products / services and the technical trade financing and maritime knowledge to develop a lending proposition. Alternatively, we should be asking, How can we differentiate STF from conventional commercial credit? For those who are interested in this topic, they can even ask, What are the similarities between STF and Project Financing, on a conceptual level?

The following diagram, which is adapted from the UNCTAD, depicts the conceptual differences between the variants of lending techniques.
Risk Transformation Risk Transformation

Without secured financing

Secured financing

Structured Trade Financing

Risks

Repayment: Is the borrower able to reimburse if transaction did not materialize as envisaged?

Collateral: Will the assets be safe from fraudulent removal?

Performance: Will the requisite goods be produced?

In essence, it is not about structuring trade finance. There is nothing in trade finance that warrants structuring. It is about structuring deals, which are trade finance-focused.

Ravi: We are curious to know the history of structured trade finance.

Could you please tell how this concept originated and who pioneered the practice of structured trade finance when and where?

Chen: If my memory does not fail me, the forefather of STF was the classic
Sonangol Deal. It involved the financing of an Angolan national oil company, involving the finance arm of British Petroleum, alongside financial institutions such as the Union Bank of Switzerland, Bankers Trust and others. At that point in time, the composite structure comprised (i) a government entity, (ii) purchaser of the underlying commodity and (iii) banks. The history of STF is an interesting one, as the lending techniques evolved over the years. Interested readers could refer to the Year 2003 publications of the Trade Finance Magazine. Several articles had been written on this topic.

Ravi: You have told us the meaning of structured trade finance. We

wish to know as well the purpose or objective of structured trade finance. Where, why, how structuring of trade finance is helpful is structuring for customization of financing services or for risk management?

Chen: This question warrants an extensive coverage, a chapter of one book,

perhaps. However, without delving into detail practical examples, it is difficult to demonstrate the importance of structuring. The objectives of structuring are varied and following is a list of just a few: 1. 2. 3. 4. 5. Risk re-allocation. Avoiding restrictive covenants on the borrowers corporate balance sheet. Segregating the proposed deals liabilities from the borrowers corporate balance sheet, from a commercial and accounting perspective. Potential entry into markets and access to customers, which may not be readily accessible via conventional lending regime. The potential to reinforce bank-client relationship by offering alternative financing methods, especially in difficult times.

Structuring of trade deals is necessary to facilitate trade whilst balancing the financiers interests i.e. risk management. As a thoughtstimulant, perhaps, one could consider the role assumed by independent collateral managers.

Ravi: Having understood the meaning and purpose we now turn our
attention to the technique of structuring trade finance how structuring is done, what is included in the structure. Do you prepare a map or plan of structure? Does structuring mean methodical arrangement of different need-based products and services?

Chen:
(1)

The question encompasses sub-questions. separately. Do you prepare a map or plan of structure? Academically, the answer is a, Yes. dimensions: -

I will address them

We can approach it from 3

First, one can develop a standard framework, which can be applied from one transaction to another [note: A standard approach is generally applicable to most transactions, irrespective of complexity, as the thinking logic is fundamentally similar. The depth of which differs, however]. For example, the structurer could examine a series of considerations (nonexhaustive): Who is the Borrower? What are the underlying goods (e.g. fungible?)? The modus operandi of the proposed transaction e.g. (i) How is the commodity being sold, (ii) Who is the ultimate buyer, etc?

Once the transactional flow / scheme is determined, the structurer can delve into the specific lending mechanisms, for example, (i) funding tenor, (ii) security types [the], (iii) ring-fencing of payment, etc. Secondly, there are certain standard protective terms and conditions that the structurer can apply, as the facility terms and conditions. Thirdly, for the more complex transactions, there are minimum documentation requirements e.g. Material Adverse Change clauses, that the financiers will insist. In practice, it is difficult to design a standard aide memoir because each borrowers credit standing and financing requirements are different. More importantly, the components of a proposed deal are dynamic. A theoretic approach towards STF lending, I feel, is a recipe for disaster. (2) Does structuring mean methodical arrangement of different need-based products and services? Yes, in essence, it is. I have illustrated, in the September / October 2006 edition of (LC Monitor), that it is not always necessary to apply back-toback LCs in a back-to-back trading arrangement. [Note: I have chosen back-to-back as an illustration because it is a fairly common trading arrangement. At times, the operational risks and requirements of which are generally not well understood.]

Ravi: Is STF suitable for emerging markets only? Chen: Conventionally, STF activities are associated with emerging or what we
call, difficult markets. Not surprising, as emerging markets carry, perhaps, a wider spectrum of risks, not limiting to potential default risk, performance issues, country risk, fraud risk, etc. It is not wrong, per se, to associate STF with financing emerging markets transactions. The issue, however being, is this a holistic view? STF is a highly specialized form of lending and its applications span beyond emerging markets. In its plain vanilla application, STF is used to substantiate a loan proposition where the (i) borrowers balance sheet is thin and where the (ii) need to closely monitor the transactional flow prevails. That said, the actual application of STF is contingent on the risk appetite and practices of each financial institution.

Ravi: Is STF relevant and needed only where there is trading of

commodities, where exporters are large businesses?

Chen: Generally, commodities are involved. However, the exporters need not
necessarily be large corporates (although it can be).

Ravi: How to judge whether the structuring is perfect, workable and

purposeful I mean what are the yardsticks for determining suitability and feasibility of the structure?

Chen: John McNarama provided thought-provoking comments in his book,

Structured Trade and Commodity Finance in Emerging Markets.

www.woodheadpublising.com

Assuming if a lender gets paid on a structured deal, is it because the borrower thinks that it is about time to repay the financier or is it because the structure had worked? Which is which? One can remain skeptical. However, (1) structures have proven their worth during difficult times and (2) having structures is definitely preferable to having none at all [Caveat: Poor structuring may kill the lender, however.] The suitability and feasibility of any proposed structure is circumstances-specific. Any attempt to achieve a one-size-fits-all approach can backfire.

Ravi: In India, I never heard of trade finance product management.

Now the banks everywhere are using the practice of product management and position of product manager. Does structuring of trade finance involve jugglery of product management? Is structuring of trade finance done by the product manager?

Chen: Product management is important.

To increase fee-base income and/or commissions, the financial institution needs to get its customers to actively utilize the existing array of products. In the smaller banks, the (i) less profitable products/services and/or (ii) high-risk services [e.g. silent confirmation] are either phrased-out or not offered to customers. Product management is necessary for purposes of (1) profitability management as well as (2) risk managing the banks potential exposure.

But a trade product / service should not be mistaken as structuring a trade deal. For instance, green-claused LCs do not equate warehouse financing. Trade product / service are different from structuring. (1) Does structuring management? of trade finance involve jugglery of product

Depending on how one defines product management, the answer is, Yes. Structuring requires the lender to arrange a composite of trade finance products / services, as appropriate, to meet the financing requirements of the lending proposition. (2) Is structuring of trade finance done by the product manager? Again, it depends on how the financial institution defines Product Manager. If a Product Manager is entrusted with the role of product advisory, it is possible that the Product Managers expertise might be called upon to advise on structuring and technical (maritime practices) issues.

Ravi: My interest is LC. So obviously my interest is to know whether

LC is used as one kind of brick and mortar in structuring of trade finance. Chen: Yes, the LC plays an important role. But it may not be necessary to use LCs.

Ravi: In the scheme of structuring of trade finance, is one bank

involved or the scheme involves more than one functionaries shortterm financing bank, long-term financing bank, credit insurer?
Chen: It really depends on the complexity of the proposed trade deal.

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Breaking the news

ICC News Alert ICC appoints new Chair of banking commission Paris, 6 November 2006

On behalf of ICCs Chairman Marcus Wallenberg, ICC Secretary General Guy Sebban has appointed Regina Prehofer of Bank Austria Creditanstalt as the new Chair of the ICC Banking Commission. Ms Prehofer will be the first woman and the first Austrian to chair an ICC commission.

http://www.iccwbo.org/iccjejg/index.html

SITPRO NEWS Trade Facilitation Now!

New Letter of Credit Rules Agreed
The International Chamber of Commerce (ICC) has announced that the final text of UCP 600 was unanimously approved without changes at the Banking Commission meeting on 24-25 October. UCP600 will change some of the rules for using letters of credit and will be enforced from 1 July 2006. You can pre-order copies of UCP600 from the ICC at www.iccbookshop.com . SITPRO will also be revising its Letter of Credit Checklists and Guides for release early next year.
SITPRO News: Issue 58, Autumn 2006 SITPRO Ltd, 7th Floor, Kingsgate House, 66-74 Victoria Street, London SW1E 6SW Tel: +44 (0)20 7215 8150 Fax: +44 (0)20 7215 4242 Email: info@sitpro.org.uk

--------------------------------------------------------------------------------------------------------------------Editorial Team Editor: Ravi Mehta, Ph.D. Technical Advisor: T. O. Lee Associate Editor: Kim Christensen Contributing Editors: Jia Hao; Laxmanan Sankaran; Marek Dubovec; Jee Meng Chen; Pradeep Taneja; Zahoor Dattu Contact: lcviews@hotmail.com; www.lcviews.com