A structure of a "synthetic" loan
The term "synthetic" loan is generally used to describe an artificial financial instrument where a loan is denominated in a base currency (X) but disbursed and repaid in a different currency (Y).
If we were to break down a structure of a "synthetic loan", its life cycle would consist of the four following phases:
- Parties agree to denominate a loan in X-currency
- Disbursements and all payments under the loan are made in Y-currency and are fixed to the exchange rate available on the payment date
- A risk associated with devaluation of X-currency against Y-currency is vested in the lender
- A risk associated with revaluation of X-currency against Y-currency is vested in the borrower
Simultaneously with the disbursement of the loan, the lender usually enters into a risk-hedging arrangement (most commonly, a non-deliverable forward contract).
Under favourable market conditions, the interest rates available for the synthetic lending may be lower than the direct foreign currency borrowing, which implies a possibility for arbitrage.
What is a "synthetic" loan for a Ukrainian market?
For a Ukrainian market, a "synthetic" loan simply means a cross-border loan denominated in a Ukrainian national currency ("UAH"), but where all payments (such as disbursement of loan, its repayment, payments of interest, and any other fees) are made exclusively in a foreign currency. Therefore, while the actual currency of a "synthetic" loan is UAH, all payments under such loan are made in foreign currency.
Going into greater details, synthetic loans can be attracted by two following groups:
- all Ukrainian residents (including, Ukrainian companies, banks, and individuals) – from international financial institutions ("IFIs")
- Ukrainian banks – from any foreign lenders (irrespective of whether they have a status of IFI)
Compared to a standard cross-border lending, synthetic loans in Ukraine have a number of advantages, which are described below:
- they do not require a registration of the loan agreement prior to the first disbursement of the loan with the National Bank of Ukraine ("NBU") and, therefore, they are not subject to the maximum cost of funding limitations imposed by the NBU
- Ukrainian borrowers can make payments under synthetic loans and purchase foreign currency for such payments based merely on the provisions of the relevant loan agreement, with no need to obtain the NBU's individual licence
Future of synthetic loans on the Ukrainian market
In terms of prospects, the picture does not change much. Those Ukrainian banks that continue to lend funds attracted under synthetic loans to local small and mid-size borrowers were also the first to start attracting this artificial financial instrument.
In November 2017, the European Bank for Reconstruction and Development ("EBRD") granted its first synthetic loan on the Ukrainian market to PJSC ProCredit Bank Ukraine. EBRD hedged its currency risks through a cross-currency swap with the TCX fund. Grant financing was provided through the EU Neighbourhood Investment Facility, which helped EBRD to reduce the rate of forex risk hedging. In turn, this helped to achieve lower cost of funding in UAH.
In February 2018, a special purpose vehicle of Ukraine's state owned Ukreximbank issued senior unsecured loan participation notes denominated in UAH, where payments will be carried out in US dollars.
Similarly to the Ukrainian lending market, where IFIs and international banks are leading the way both in terms of the financing volume and introduction of new financing products, we expect that IFIs and international banks will continue to be the most active lenders able to allocate favorable FX handling arrangements. Head of Investment Banking at Raiffeisen Bank Aval, Victoria Masna, notes the following on the potential of synthetic lending in Ukraine: "Considering the fact that for many year up until now customer deposits have been the only source of UAH liquidity, this instrument might additionally boost of UAH lending on the market".
It is expected that synthetic loans should boost the availability of long-term local currency financing in Ukraine, which is currently in demand on the local market. However, unfortunately, the high volatility of UAH caused by both economic and political factors negatively affects the hedging costs for the foreign lenders (who have access to the wider set of hedging instruments as opposed to Ukrainian lenders) and Ukrainian borrowers. Thus, despite the initial market interest, synthetic lending in Ukraine is yet to become a high-demand financing instrument.
The future of synthetic loan instrument will largely depend on the market demand from the Ukrainian borrower's side and ability of foreign lenders to hedge their FX risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.