Download Structuring Local Currency Transactions: Case Studies

LocalCurrencyMatters
StructuringLocalCurrency
Transactions:CaseStudies
August2012
www.tcxfund.com
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StructuringLocalCurrencyTransactions:CaseStudies
1 SyntheticLoan(Non‐DeliverableSwap)
Box1:Transactionexample
Aninternationalprovideroflong‐termfundingapprovesa10yearloanfortheconstructionofa
powerplantintheeastofSriLanka.GiventhatelectricityincomeistypicallychargedinLKR,the
fundingoftheprojectinUSDresultsinacurrencymismatchfortheborrowerasthecostofdebtis
now dependent on the value of the LKR over the life of the loan. The international lender thus
wishestodenominatetheloaninRupees,therebyeliminatingthisriskandthusreducingitscredit
risk.Inordertohedgetheassociatedmarketriskwithalocalcurrencyloan,thelenderentersinto
anoffshorenon‐deliverablecurrencyswapwithTCX.Thisallowsthelendertoearnaguaranteed
USD denominated return whilst the borrower receives local competitively priced Sri Lankan
RupeeLoan.Byprovidinghedgingandlocalagencyservices,TCXfacilitatesthecreationofalocal
currencybusinesslineforitsinternationalinvestorsandinthismannerachievesitsmission.
Thesequenceofcashflowscanbechronologicallydescribedasfollow;
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OnthedayofdisbursementbothpartieshaveagreeduponaloandenominatedinLKR.Thelender,
an international development finance institution (DFI) disburses a 10‐yr term loan transferring
USD from his offshore bank account to the onshore bank account of his client (borrower). The
clientwillexchangetheUSDforLKRinthespotmarkettousetheproceeds(inLKR)toachieveits
economicobjective.
The term synthetic refers to the fact that, although the principle amount of the loan is fixed in Rupee and the interest rate payable by the borrower is determined using local interest rate benchmarks, the actual payment flow between the lender and its domestic client is settled in hard currency (often USD), offshore At the moment of disbursement, the DFI (lender) puts in place a cross
currencyswapwithTCXtohedgeitscurrencyexposure.Underthetermof
the swap the lender receives Libor 6‐m + 3% in USD from TCX (its credit
marginontheborrower)andpays13%inLKRtoTCXover10years.The
rateof13%quotedbyTCXwillbeusedbythelendertounderwritealocal
currencyagreementat13%LKRperannum.Thehedgeintendstoprotect
the lender from LKR depreciation. The lender is able to provide a loan in
LKR instead of USD because it could hedge the currency and interest rate
exposure with TCX. The product provided by our investors to Sri Lankan
borrowers that involves a loan and a USD/LKR cross currency swap is
calledasyntheticloan.
Theclienthasnowtopaythefirstinterestpaymentonthetermloan(andamortizeaportionof
theloanifapplicable).Thepre‐agreedinterestamountinLKR(13%)istradedinthespotmarket
atalocalbankorbureaudechangefortheequivalentinUSD.PaymentsaredenominatedinLKR
with the payment obligations converted to hard currency on the date of payment, and payment
deliveryinthelender’sbankaccount(eginLondon).
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It is interesting to note that the swap is a non‐deliverable swap in the sense that the lender does not pay a 13% flow in LKR to TCX against of payment of 3% in USD from TCX. TCX (the payment agent) offset the two flows on a USD basis so that one single cash flow is paid or received in USD A word of caution is that TCX uses generally a central bank fixing for non‐deliverable swaps. As a result, the borrower is required to remit the funds to the lenders in USD at each fixing at the prevailing fixing rate (although the loans are denominated in LKR). That obligation creates a ‘liquidity risk’ for the borrower who has to match the fixing rate of the swap when trading the USD/LKR in the spot market. The difference between the central bank fixing rate and the rate traded in the spot market can generate a profit or a loss for the borrower. 4
Atthisstagetwoscenariosmayoccur(i)theLKRhasdepreciatedinwhich
casetheUSDamountthattheclientobtainedfromthespotmarketisless
than the initial USD interest payment expected by the lender. This loss is
bornebyTCXwhichundertheswappaysthedifferencetothelender.The
borrower is immune to a potential LKR depreciation as the stream of
interestpaymentshavebeendefinedinLKRor(ii)theLKRhasappreciated
inwhichcasetheamountofUSDremittedoffshoreonthebankaccountof
the lender is superior to the initial USD interest expected by the lender.
ThissurplusisagainforTCXrecoupedundertheswap.
Time has come to repay the principal. Again, the borrower exchanges the
principal amount pre agreed in LKR as stated in the loan agreement into
USDatthepaymentdateandtransferstheUSDoffshoreontothelender’s
account.
Again in case of a depreciation of the LKR the lender receives an USD
principal eroded by the LKR depreciation. TCX will settle the difference
withthelenderundertheswapagreement.
2 Domesticlocalcurrencyloanstructure
Box1:Transactionexample
Aninternationalprovideroflong‐termfundingapprovesa10yearloanwitha5%interestratefor
theconstructionofapowerplantinDominicanRepublic.Giventhatelectricityincomeistypically
chargedinDOP,thefundingoftheprojectinUSDresultsinacurrencymismatchfortheborrower
asthecostofdebtisnowdependentonthevalueoftheDOPoverthelifeoftheloan.Theclient
wishesobtainfromthelenderalocalcurrencyloandenominatedinDOP,therebyeliminatingthis
riskandthusreducingitscreditriskandimprovingitsfundingandrating.Inordertohedgethe
associated market risk the lender enters into an offshore conditional deliverable currency swap
withTCX.ThisallowsthelendertoearnaUSDdenominatedreturnwhilstofferingtotheborrower
alocalcompetitivelypricedDominicanPesoLoan.Inthatcase,thelendermarginofUSD5%fixed
is translated to DOP 22% fixed. By providing hedging, TCX facilitates the creation of a local
currencybusinesslineforitsinternationalinvestorsandinthismannerachievesitsmission.
TCX currently only offers deliverable swaps in Dominican Republic (DOP), Ghana (GHS), Honduras (HNL), Kenya (KES), Nigeria (NGN), Tanzania (TZS), Uganda (UGX), West African CFA Zone (XOF), and Zambia (ZMK) –. More countries will be added based on demand, thus please contact us should you wish to do a deliverable swap (domestic loan) in another country 5
On the day of disbursement, TCX Client transfers the USD principal of the
loan directly to TCX. TCX ‐ via its settlement partner(s) ‐ conducts an
auction for the conversion of the USD into DOP. The auction typically
includesbothlocalandinternationalbanksactiveintherelevantmarketto
ensure the best rate available in the market is obtained. The DOP are
delivereddirectlytotheborrower.
TheDFI(lender)hedgestheCurrencyandInterestRateRiskoftheUSDloanthroughaCross
CurrencySwapwithTCX.
Upon repayment of the principal and/or interests, the borrower transfers the funds in local
currencydirectlytoTCX’sbankingaccountonshore.Atthesametime,TCXtransferstheUSDcash
flowstreambacktotheTCXClientafterhavingsimultaneouslyrunauctiontoexchangetheclient’s
DOPintoUSD.TheeleganceofthestructureisthatTCXusestheforeignexchangerateresulting
fromtheauctionateachfixingdateoftheswapasopposedtoacentralbankfixinglikeitusually
doesfornon‐deliverableswaps.Asaresult,theliquidityriskbornebytheclientisnowshiftedto
TCX.
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Pleasenote:

ThespotFXbid‐askspread1ispricedintothedeliverableswap.Thisistoreflectthetransferof
liquidityrisktoTCX.Pleasenotethatthisisnotanadditionalcharge,astheborrowerwould
also incur a bid‐offer spread when converting LCY into HCY for offshore payment under the
synthetic(non‐deliverablestructure).Theinclusionofthebid‐offerintheswapprovidesthe
borrowerwithpricingcertainty;

TCX’ssettlementpartnerhas20yearsexperienceinsettlingspottradesinemergingmarkets
andthusweareabletominimizeoperationalandsettlementrisk;

Thefullprocessincludingtheauctionisfullytransparentwithanaudittrailtoprovidecomfort
toTCXClients;

The deliverable swap is conditional in that the structure reverts to a non‐deliverable swap
upon(i)adefaulteventundertheloanagreementand(ii)convertibility/transferriskevent;

InorderforTCXtoprovidethedeliverableswap,additionalinformationontheborrowerwill
be required including KYC documentation. We thus encourage you to contact us early in the
lifeofthetransactiontoensurewecanmeetyourtimelinerequirements.

Clearanceofthecentralbankmayberequiredinsomecountries(ex.PHP)priorto
disbursementtorapatriatethefundsthereafteroffshore.
1Thebid‐askspreadisthedifferencebetweenthepriceatwhichabankormarketmakerwillsell("ask",or"offer")and
thepriceatwhichamarkettakerwillbuy("bid")fromacustomer.
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2.1
Comparingsyntheticversusdomestic
Both structures have advantages and disadvantages which should be considered. These are
summarisedonthefollowingpage.
Pro’sandcon’sofsyntheticverusdomesticstructures
Syntheticloans
(Non‐deliverableswaps)
Domesticloans
(Conditionaldeliverableswaps)
Pro’s  Available for all currencies  Superiorspotratesviaauctionprocess
whereTCXcantrade
 Auction rate used in both swap and
 Dollarsettledflows
loan agreement, thus no potential for
mismatch
 Limitedlegalrisk
 LoanadminsimplifiedforTCXClient
 Noextracharges
 Borrowerpaysdomesticallyandisnot
responsibleforconversionoffunding
 Transfer and mitigation of liquidity
risktoTCX
 Enhanceddevelopmentimpact
Con’s  TCX Client responsible to  Currently only available in 9
currencies
source liquidity and manage
physicalflowoffunds
 Local FX controls and regulations,
legalriskcancomplicatestructure
 Spot rate used in swap may
differ from actual rate used in
 Costs for execution the payment
loanagreement
services
 Transferriskandliquidityrisk
forborrower
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Insummary,thefollowingtablesumarizestheriskallocation betweenthecontractingpartiesin
thetwostructures.
Riskallocationinsyntheticanddomesticstructures
Syntheticloan
Domesticloan
(Non‐deliverable
swap)
(Conditional‐
deliverableswap)
MarketRisk
TCX
TCX
CreditRisk
Lender
Lender
Hedge/LoanMatchRisk Lenderor Borrower
None
LiquidityRisk
Borrower
TCX
ConvertibilityRisk
LenderorBorrower
Lender/Borrower
SettlementRisk2
LenderorBorrower
TCX
2
This is the risk of the local bank that performs the transfer does not perform.
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3 Directhedgingofexposuresforclientsofinvestors(Non‐Deliverable
Swap)
Box1:Transactionexample
An international provider of long‐term funding (the lender) approves a 5 year loan to a local
microfinanceinstitution(theborrower)inKyrgyzstanwitha5%interestratefortheexpansionof
thebank’smicroandSMEportfolio.GiventhattheborroweronlendstoitscustomerbaseinSom
(KGS), the funding of the project in USD results in a currency mismatch for the borrower as the
costofdebtisnowdependentonthevalueoftheKGSoverthelifeoftheloan.Theclientwishesto
hedgewithTCX,therebyeliminatingthisriskandthusreducingitscreditriskandimprovingits
funding,ratingandprudentialratios.Inordertohedgetheassociatedmarketriskthecliententers
into an offshore non‐deliverable currency swap with TCX. This allows the lender to earn a USD
denominated return whilst the borrower synthetically receives a local competitively priced KGS
Loan. By providing hedging, TCX facilitates the creation of a local currency business line for its
internationalinvestorsandinthismannerachievesitsmission.
Thesequenceofcashflowscanbechronologicallydescribedasfollows:
Theclientagreeswithaninternationallenderuponalong‐termloan.Afterfulfillmentofallpre‐
conditions,theclientobtainsadisbursementoftheprincipalamountfromthelender,paidinUSD,
whichisimmediatelyexchangedforKGSinthespotmarket.TheKGSproceedsareusedtopursue
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the economic raison d’être of the loan (i.e. servicing micro and SME customers). For illustration
purposes,let’sassumethatthetermsoftheloanarethefollowing:theclientborrowsUSDfrom
thelenderatafixedinterestrateof5%perannumoveracertainperiod.
Atthesametimeasreceivingtheloanproceeds,thecliententersintoacrosscurrencyswapwith
TCXtohedgetheunderlyingloandisbursedinUSD.Again,forillustrationpurposes,letusassume
that the terms of the swaps are the following ; the client hedges the full loan principal and the
stream of interest payments defined in the loan agreement over the maturity of loan. Regarding
theinterestpayments,theclientwillbereceivingfromTCXastreamofinterestrateinUSDsetat
5%fixedofthenotionalcorrespondingtowhattheclientmustpaytoitslenderundertheexisting
loanagreement.InexchangeofwhattheclientwillpaytoTCXinKGSarateof6‐mT‐Bill+530bp
(benchmarked against prevailing rates on the execution of the trade). Furthermore, all future
repaymentobligationsoftheloanprincipalareagreedtobehedgedwithTCXatanFXrateequal
tothespotrateonthemomentoftheclosureofthedeal(T‐2).
The ability of the client (borrower) to hedge directly with TCX enables him to hedge USD liabilities contracted with non‐TCX investors. 11
Inotherwords,theaggregateliabilityoftheclient,whencombining
the USDloan withthe hedgeprovided by TCX,isnow transformed
into a KGS liability against a local benchmark (6‐m T‐Bill). All
interests and principal repayment obligations for the USD loan are
mirroredintheswapandtransformedintofloatingKGSobligations.
The lender is now fully hedged against any currency moves in the
USD/KGS. The benefit of the swap is that the client has now
managedtotransformsyntheticallyaUSDloanintoaKGSloan.
The 5% annual interest paid by the client to the DFI in USD cancels out with the USD leg of the
swapwhereTCXpaysUSD5%totheclientwhereastheclientpaysKGS6‐mT‐Bill+530bptoTCX
undertheKGSlegofthesameswap.
Thecashflowssumupinthisfashion;
(‐)theclientpaysUSD5%
undertheloanagreementtothelender
(+)theclientreceivesUSD5%
undertheswapagreementfromTCX
(‐)theclientpaysKGS6‐mT‐Bill+530bp
undertheswapagreementfromTCX
=
(‐)theclientpaysKGS6‐mT‐Bill+530bp
throughtheswaptheclientachievedtosecurea
syntheticloaninKGSat6‐mT‐Bill+530bp
This structure allows the client to define the characteristics of the swap (notional, timing of
implementationofthehedge,typeofratechosen,swappingthecreditmarginornot,maturityof
the swap) to offset with greater precision the currency risk mismatch embedded in its balance
sheet.
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CurrencyRiskvs.InterestRateRisk
It is interesting to note that the client has swapped a USD fixed liability (5% USD loan) into a
floatingKGSliability(6‐mT‐Bill+530bp).Thecurrencyriskisfullyhedged.Theinterestraterisk
ishedgedaswellaslongastheclientunderwritesloansonthesamefloatingbenchmark(6‐mT‐
Bill+themarginofthebank).IftheclientwastoswapfixedUSDvs.fixedKGSwhilstonlendingto
itscustomersonafloatingbasis,thebankwouldinevitablyrunaninterestratemismatch.
When time has come to repay the principal, the borrower exchanges KGS into USD to repay the
principalamountdenominatedinUSDtothelender.Simultaneously,theclientreceivesfromTCX
(incaseofaUSDappreciationsincethetradedate),orpaystoTCX(incaseofaKGSappreciation
sincethetradedate),thedifferenceoftheagreednotionalon bothsidesoftheswap.Thisvalue
will compensate the client for any changes to the USD/KGS exchange rate since the trade date.
PleasenotethatinexchangeforthebenefitincaseofaKGSappreciation,theclienthasgivenupon
any gain on the loan principal in case of an appreciation of the KGS against the USD. The swap
matureswiththeloanfinalprincipalrepayment.
To summarize in this case the investor provides a USD loan to the local client, who hedges the
resulting obligation with TCX. This has the benefit of avoiding complications at the level of the
investorandintheloan,butmayhavedrawbacksasitrequiresTCXtoaccepttheendclientasits
counterparty.Anadditionalbenefitofthisstructureistheabilitytodecoupletheclient’scurrency
hedgingneedsfromthespecificinvestorloan,intermsoftimingorothertransactionterms.This
option is only available to institutions which have a funding relationship with a TCX Investor
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(DFI’s). This structure offers a clear advantage as advocated by (Barry Eichengreen, Ricardo
HausmannandUgoPanizza,“TheMysteryoftheOriginalSin”,2003)asmarketparticipantsmay
prefer to separate these risks in order to facilitate the pricing of risk and thus facilitate the
developmentofmarketliquidity.
TCX was created to absorb market risks ‐ more specifically foreign exchange and interest rate
risks.TCXthereforeseekstominimizeitscreditriskexposure.
Incurrencyderivatives,creditriskatthestartofaswapiszerobecausetheamountpayableand
receivablebyeachpartyisexactlyinbalance(thedealispricedtoachievethisbalance).However,
as time passes, FX and interest rates fluctuate, disrupting the balance and leading to one party
owingtheothermoney.Ifthatpartydefaults,thenetamountowedislostbytheotherparty.
Through Interim payments a minimum transfer amount is paid by TCX to its counterparty or
receivedbyTCXfromitscounterpartytomitigatetheevolutionofthevalueoftheswap(themark‐
to‐market.)Thetwopartiesareentitledtomakepaymentsarisingoutofamutualagreement.The
terms of this bilateral agreement are confined in Credit Support Annex (CSA). Collateral is the
industrystandardwaytomitigatethecreditriskarisingfrom"inthemoney"derivativepositions.
Moreinformationcanbefoundon:https://www.tcxfund.com/trading‐with‐tcx/collateral‐terms‐
with‐non‐investors
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Furtherinformation
Please contact the TCX Structuring Team for further information and to explore specific
transaction opportunities. Please refer to TCX’s website, www.tcxfund.com, for more details on
TCX’sinvestmentproductsandtherequirementstotrade.
TCXStructuringTeam:PervanSwaay,JorgeGomes,JeromePirouz
Email: [email protected]
Tel: +31205314851
Address:
TCXInvestmentManagementCompanyB.V.
Sarphatikade14
1017WV
Amsterdam
TheNetherlands
www.tcxfund.com
Disclaimer
TheCurrencyExchangeFundN.V.(TCX)isstructuredasanopenendinvestmentfund.Thestatutorymanaging
directorofTCXisTCXInvestmentManagementCompanyB.V.(TIM).Accordingto1:12sub1bActonfinancial
supervision TCX and TIM are exempted from the obligation to obtain a licence from the Authority for the
financialmarketsasonlyqualifiedinvestorsmayinvestinTCX.Thecontentsofthispresentationshouldnotbe
consideredasanadvicetoparticipateinTCXorpurchaseanysecuritiesofferedhereby.
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