Ever wondered how Financial Instrument Leasing Really Can Work?
Many people have asked me over the years, who they can lease a Financial Instrument from that is real. The short answer, is that they can get a Bank Instrument from any bank. But as far as leasing it, there are many ways to lease on but it is not the way that many individuals present them.
In short, bank instruments can technically be leased from an account holder or a bank themselves, but if you are thinking that this is something that can be used to take a loan against so that you can fund your project or use for some other investment, you will not like the answer I am going to give you.
|Most Common Financial Instrument Types: Standby Letters of Credit (SBLC), Letters of Credit (LC), Documentary Letters of Credit (DLC), Transferrable and Non-Transferrable Letters of Credit|
Before I answer that question, let’s put this into a perspective so that you will likely come to your own answer.
Scenario: You Have $1 Million to Invest
Imagine you are a person who has amassed $100 million dollars by perhaps having a very successful business, a build-up of your family’s wealth over the years or perhaps even winning the lottery. Now imagine that you have this cash sitting in a top rated bank and you are interested in investing it. Someone contacts you with the interest of using your money as collateral for a business idea they have. Their idea is that you leave your money in the bank and put a block on it, in favour of the business idea that this person has and they will pay you 3% of the face value of the funds which are blocked.
Next this business person is going to a different bank, and he is going to request a loan from that bank, using the Bank Instrument issued from the bank holding the cash. So that other bank would lend 80% of the face value of the Financial Instrument. Once the bank loan has been created, and the advance of funds done, the person that is using the Bank Instrument defaults on the payment to the lending bank so the lending bank calls the Bank Instrument from the bank holding the cash and because you have allowed that account to be collateral, the lending bank has the right to the cash due.
Now, you have lost your $100 million dollars for the $3 million dollars service fee and lost your deposit.
In light of this perspective, is this a transaction that you would enter into if you were the holder of the $100 million deposit? You answer likely is no, so now you have answered your own question but at the risk of overstating the obvious, why would someone risk any deposit amount for a small return on investment as shown in this scenario? Answer: They would not.
So is there a way to Make Financial Instrument Leasing Actually Work?
All this being said, there is a way to make it work, but I promise you, it will not be simple but before I start, I want to say right now, I am not an Investment Advisor and in no way represent any one with respects to investments, this is merely a mechanics discussion.
The most common way to get a guarantee on the principle amount would be similar to getting a Guaranteed GIC (Government Investment Certificate). In these cases, you would get a very modest return on investment which is guaranteed by the government which is using your money while it sits in their account. Most banks will offer Investment Certificates in a similar format.
It is possible for one to use these Financial Instruments as collateral to guarantee a loan but if the loan defaults, the lender will assume title of the Financial Instrument as their exit strategy to cover the loan repayment.
To expand upon this, if the owner of the Financial Instrument wishes to use their account as collateral for the loan for your investment, they will definitely want to have a say, if not control the use of funds of the loan of which they are providing the guarantee for. In reality, there is no difference between this and the guarantor using their home a collateral for the loan being taken out.
Question: Have you ever been or asked someone to be a guarantor for a loan?
If so, you likely know that the guarantor is putting themselves at risk for that loan and if it is not paid as agreed, the guarantor stands to lose whatever it is that was put up as a guarantee. Even if the guarantor did not put any actual assets at risk because their credit standing was strong enough to support the collateral requirement on a personal basis, they still will be held personally responsible.
Knowing the nature of how the Financial Instrument works and what the underlying repercussions are, how likely would you be to put up your $100 million Financial Instrument for lease for 3% of its face value, without proper securities being in place to protect you from losing it? Most people would not consider it as the potential of a loss has not been mitigated.
Those that hold out the idea of being able to monetize a leased Bank Guarantee (BG) are selling a fairy tale as no lender will advance funds on a Financial Instrument that is not owned. Think of it as trying to refinance a property that you rent.
Would any bank give the tenant paying rent on a property a line of credit against that property when they are not the owner of the property? This is within the realm of ridiculous, but many people are drawn in with the possibility extraordinary returns and will overlook the obvious for the opportunity being presented to them.
Most of these fairy tales will come with upfront costs and are offered through “brokers” and “mandates”. Many of whom are not suspecting that the underlying concept is a deception and get looped into the operation quite innocently. Countless times only few of the people involved actually know what is really going on. The upfront fees are accumulated then split between the parties or passed along to the organizers of the fairy tale. There is always some excuse as to why the transaction did not complete.
The Practical Use of Financial Instrument Leasing
Now that a very gloomy picture has been painted of Leasing Letters of Credit, I will discuss how it is most often done in Commercial Finance, in particular, with Purchase Order Finance.
Before I do, it is necessary to define what a Purchase Order is:
A purchase order (PO) is a commercial document and first official offer issued by a buyer to a seller, indicating types, quantities, and agreed prices for products or services. It is used to control the purchasing of products and services from external suppliers. Acceptance of a purchase order by a seller forms a contract between the buyer and seller, and no contract exists until the purchase order is accepted.
Purchase Order Finance is the financing of an arm’s length transaction where a third party provides a payment guarantee to the seller of the goods, according to the terms of the Purchase Order. In order for the third party to provide this guarantee, there are certain requirements and covenants which must be stipulated and followed in order for the third party “guarantor” to guarantee the payment to the seller.
In order to demonstrate the steps of how a Financial Instrument is used as a payment guarantee, I am going to provide a Use Case as this will demonstrate the process better that merely speaking to the mechanics of the process.
Supplier – ACME Fabrica SSA (ACME), Santiago, Chile
End Customer – Whoopi Chair Cushions LLC (WCC), Seattle Washington USA
Distributor (Client and Facilitator) – CAN Logic Ltd (CLL)., Vancouver, British Columbia Canada
In this scenario, the distributor, CAN Logic Ltd. is a broker. It has a sale supplies to Whoopi Chair Cushions LLC and has sourced the goods from a factory called ACME Fabrica SSA.
ACME is happy to fill the order but they want to have a payment or a payment guarantee before they will begin making the goods. WCC has terms with the distributor of net 30 days after delivery of the goods to their warehouse and CLL does not have the financial means to pay the manufacturer until they receive payment from the end customer. On the outset, this looks like a transaction that has too many impediments to happen.
- The end customer, WCC must be creditworthy; and,
- The transaction cost from the supplier must be over $50,000 USD; and,
- CLL must be experienced in this type of transaction; and,
- ACME must be a verified as being a capable supplier; and,
- CLL must set up an Accounts Receivable Facility. It will be used to convert the Purchase Order into an Accounts Receivable Factoring advance upon delivery and acceptance of the goods; and,
- The supplier, ACME, must accept to be paid upon delivery and acceptance of the inspected goods at WCC’s the end customer, warehouse.
This is the order of events to successfully complete the Use Case transaction in a very simplified manner.
- CLL (the distributor) makes a deal with ACME (the seller of the goods); then,
- CLL makes a deal with WCC (the end customer); then,
- CCL provides the purchase orders to the finance company; then,
- The finance company will verify all information pertaining to the transaction. This will include the Purchase Order from CLL to ACME, the PO from WCC to CLL, the creditworthiness of WCC, the performance capacity of ACME, and the performance history of CLL; then,
- The finance company will negotiate the Letter of Credit with ACME; then,
- The finance company will create an Accounts Receivable Factoring facility for CLL, then,
- ACME will deliver the goods to WCC, then,
- WCC will confirm the goods delivered are acceptable and meet the specifications per the PO to CLL; then,
- The finance company will give an advance on the Receivable to CLL to pay the invoice to ACME as specified in the Letter of Credit; then,
- WCC will pay the invoice when due to the Finance Company; then,
- The Finance Company will deduct the amount of funds paid to ACME. Then they will pay the difference to CLL less the finance fee.
As mentioned, this is an over-simplified example of how the transaction will work. This Use Cash shows how a Financial Instrument is used to guarantee the payment of a debt to a supplier. The fee for the lease of the Financial Instrument, in this case, will be deducted from the proceeds of the transaction. There are times where the fee for leasing the Letter of Credit will need to be paid before its issuance. The process will remain the same with the exception of the LC lease payment being required before the LC issuance.
Hopefully this article has adequately demonstrated that Financial Instrument Leasing is possible and how it is done. It should be clear that those that an offer of a Leased Bank Guarantee for the purposes of monetization or security for a loan as well as those that claim to be able to leverage a leased BG are selling a scenario that is not real. That is of course, unless the owner of the Financial Instrument has control of the loan proceeds. There is a possibility it may be serious if they wish to protect their principal amount.
In the end, if the situation is too good to be true, it typically is.
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