Article

by Jee Meng Chen

Is there a risk-free trade financing proposition? Despite the lure of making a profit with zero risk, any novice in economics will tell you that "there is no such thing as a free lunch."

The following case deals with a rather unique trade proposition that seemed to defy the conventional risk-reward equation. If you are presented with a supposedly risk-free deal, would you go for it? What could be the dangers and the unaddressed issues?

Trade modus operandi

SPT was a smallish general trading house with more than 20 years of experience specializing in a wide spectrum of goods ranging from capital goods, e.g., tractors to soft commodities to consumer products. [Risk note 1: From a lending perspective, a financier draws comfort from the specialized knowledge of a trader with accumulated years of experience.] In the last ten years, however, SPT had acted as a "trade facilitating agent"; that is, "lending" its trade facilities to other financially strapped trading companies in the region.

In this case, SPT approached UBL for trade facilities of USD 3 million, having the following structure:

1. A trading intermediary, NML (to be approved by UBL), would broker a deal between the ultimate buyer and supplier;

2. Upon receipt of a confirmed purchase order from the ultimate buyer, NML would source for the supplier;

3. The contracted supplier would require the issuance of an L/C prior to shipment. Interestingly, though, the supplier was agreeable to accepting an inoperative L/C. In addition, the supplier understood that the L/C would remain unutilized and payment would be settled outside the L/C terms. [Risk note 2: inoperative L/Cs are used under specific circumstances. Why would the beneficiary agree to "waive" the protection accorded under UCP?].

4. As NML had limited access to banking facilities, it relied on trade facilitating agents, in this instance, SPT, to issue the L/C on its behalf to the supplier. To mitigate the risk of NML negotiating the L/C, certain provisions would be instituted to safeguard UBL's position.

5. UBL would issue the L/C to the supplier's nominated advising bank in accordance with SPT's instructions.

6. Once the goods were available for collection, NML would inform the buyer so that it could inspect and take delivery of the goods. [Risk note 3: Both the L/C applicant and L/C beneficiary lose control of the cargo.] As the credit terms were accorded to the buyer, NML needed to factor the receivables for upfront cash to reimburse the supplier.

The schematic trade flow of the transaction is illustrated by the following diagram:

Risk analysis

In approving the trade credit facilities, UBL considered the following risk factors:

1. Documentary credit requirement

The issued L/C would incorporate a clause stipulating the issuance of an inspection certificate prior to the shipment date by SPT in the form of an authenticated SWIFT advice from UBL to the nominated advising bank. The original SWIFT advice was required for negotiation of the documents. Moreover, the seller acknowledged that UBL assumed no responsibility for the delay or even the non-issuance of the SWIFT advice. But what remained unanswered was: why would the seller accept such a disadvantageous clause?

2. Bank's credit risk exposure

UBL would not be exposed to credit risk, i.e., payment liability as an issuing bank if the L/C applicant defaulted, since the issued L/C would remain inoperative. Under the proposed trade structure, the proceeds of the factored debts would be used to pay off the supplier.

In the event the seller was required to present documents for negotiation, SPT agreed to fully cash-collateralize the L/C prior to UBL's issuing the inspection certificate through SWIFT.

3. Transactional risk exposure

Neither SPT nor UBL would be exposed to transactional risk exposure. First, SPT would not partake in the actual trading transaction and, should the deal fall apart, the issued L/C would be inoperative. Second, with payment to be settled outside the L/C terms, UBL would not be exposed to documentary checking risks.

Unexplained issues

While the viability of the proposed trade facilities hinged on the supposed risk-free features of the trading structure, several issues remained unanswered:

1. Unknown entity relationships?

The L/C was structured in a fashion that prohibited documentary negotiation, as control resided in SPT, the L/C applicant. Moreover, the credit proposition did not articulate why the supplier would be ready to accept an inoperative L/C, i.e., settlement outside the L/C terms. And additionally, the supplier would lose control of the cargo and have virtually no recourse to SPT and/or UBL.

With such disadvantageous trading terms, it would appear that the seller had a reasonably (or unreasonably) high level of trust in SPT and NML.

2. The credit risk mitigation fallacy

On the surface, the prospect of SPT agreeing to fully cash-collateralize the L/C exposure prior to issuing the inspection certificate looks attractive. However, on further analysis, it did not make transactional sense. First, SPT was a trade facilitating agent with no interest in the underlying goods; in which case, why would SPT commit to perform pre-shipment inspection and to incur additional costs? Second, to issue the inspection certificate via SWIFT would require a 100 per cent cash deposit. This, however, did not tie in with SPT's role as a trade facilitating agent, as the company would have to assume the credit risk exposure of the buyer. Given that most small- and medium-sized trading houses are financially strapped, would it be within SPT's financial ability to cash-collateralize the issued L/Cs? And what would be the source of the funds?

3. Settlement outside L/C terms

As the proposed L/Cs would be left to expire without negotiation, UBL would never see the physical trade documents. And it would remain unknown whether shipment actually took place. While UBL was the L/C issuing bank in name, in reality it was no more than a financial postbox. While L/Cs can be creative, are they designed to work in this way?

4. The math doesn't add up

It is important to consider the mathematics of the transaction, i.e., did the trade deal make economic sense?

Assume the following figures:

- the notional shipment: circa USD 1 million;

- the all-in factoring rate: 15 per cent;

- the spread for NML: 1 per cent; and

- the spread for the buyer: 4 per cent.

Using a simple calculation, the buyer would end up paying at least USD200,000 above market price for the said commodity. Depending on the commodity type as well as the prevailing supply and demand, this might well be possible. In addition, if one takes into account (i) the payment of the freight charges and (ii) the commission due to SPT, the difference between the prevailing market price and the contracted L/C amount would have widened considerably. And what if the buyer, in this instance, turned out to be an intermediary trader who needed to on-sell the product? If these assumptions were true, the price differential would not make sense.

Developments

In any case, UBL accorded the trade facilities on a transactional basis, i.e., the trade deal was assessed and approved on a case-by-case basis. After trying it out for around 18 months, the fee income looked good, without any operational issues. When the account was due for review in the second year, SPT proposed to increase the facility limit to USD 6 million. The result was not surprising: the local credit committee revised the limit in expectation of more deals and, of course, fee income at zero risk.

Afterthoughts

Taking an independent look at this case, one cannot help but return to the dangers and the unaddressed issues. If something appears too good to be true, it probably is. One should take a step back and ask, "Why me?" And if your bank is offered a deal with a similar modus operandi, clearly it should stay away from it at all cost unless the bank is totally satisfied that the deal makes transactional sense. Above all, leave no stone unturned when using know your customer and due diligence.

Jee Meng Chen (Singapore) is a freelance writer on general banking topics.
His e-mail is Chen.JeeMeng@uobgroup.com