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LocalCurrencyMatters StructuringLocalCurrency Transactions:CaseStudies August2012 www.tcxfund.com 1 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; 2 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). 3 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. 6 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. 7 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 8 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. 9 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 10 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. 12 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 13 (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 14 4 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. 15