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Synthetic letters of credit

Basically, a letter of credit is meant to serve as payment guarantee in the international transactions. With a letter of credit, the buyers are able to provide secure terms of payment to the sellers and one or more banks are involved. Technically, a LOC is normally referred to as a documentary credit. A synthetic letter of credit is the one that is already pre-funded by the bank on the date of closing rather than when the funds are drawn as desired. All the cash that is accessible through the synthetic LOC are normally held in a credit linked deposit account until needed. Compared to an ordinary LOC, the synthetic LOC is a more liquid source of funds to the borrower because the funds borrowed via the synthetic LOC are given immediately. Therefore the proceeds are considered to be more secure because of the absence of the counterparty risk that could be brought about by the funds becoming unavailable. The main reason as to why the synthetic letter of credit were invented was to offer protection to the lending institutions as well as borrowers during bankruptcy proceedings. The lender’s risk participation is prefunded by the bank which issues a loan; this is achieved by the bank holding back some amount of the lender’s money. There is no interest that is gained by borrowers as well as the lending institution. Compared to the ordinary letters of credit, the synthetic letter of credit is a more liquid source of funds to the borrower. The reason behind this is that the funds borrowed through the synthetic letter of credit are given immediately. Due to this, the proceeds are thus considered to be more secure than from any other source. This is because there is no counter party risk which could be brought about by the funds becoming unavailable.