UBS explains the standby letter of credit.

(emphasis mine) [my comment]

Standby letter of credit

The standby letter of credit comes from the banking legislation of the United States, which forbids US credit institutions from assuming guarantee obligations vis-à-vis third parties. To circumvent this rule, the US banks created the standby letter of credit, which is based on the "Uniform Customs and Practice for Documentary Credits (UCP 600)".

Similarities with the guarantee

Like the guarantee, the standby letter of credit is of an abstract nature, i.e. legally separated from the underlying transaction. In the case of a standby letter of credit, the documents stipulated in the claim must be submitted within the specified period. These documents should show that the client (exporter) has not met or insufficiently fulfilled his or her performance obligations or the debtor has not met a payment on time.

The standby basically fulfils the same purpose as a guarantee: it is payable upon first demand and without objections or defences on the basis of the underlying transaction. It is up to the beneficiary to decide whether a standby may be given.

The OCC and standby letters of credit

Onechicago reports about the Options Clearing Corporation's financial guarantee.

The Options Clearing Corporation (OCC) is the world's largest derivatives clearing organization. Operating under the jurisdiction of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), OCC issues and clears U.S.-listed options and futures on a number of underlying financial assets, including common stocks, exchange-traded funds, currencies, stock and volatility indices, and interest rate composites. In addition, OCC operates a centralized facility for administering stock loan transactions between participating clearing members. As a part of that facility, OCC guarantees the mark to market payments in respect of such stock loan transactions. In 2007, OCC cleared more than 2.8 billion contracts. 2008 options volume is more than 2 billion.

...
OCC's second line of defense against clearing member default is a clearing member's margin deposits. Margin refers to cash, letters of credit, eligible U.S. and Canadian government securities, debt securities of eligible government-sponsored enterprises, corporate debt and equity securities, money market fund shares or other forms of eligible collateral deposited by a clearing member to satisfy its margin requirement with OCC. At the end of 2007, OCC held approximately $115.8 billion in aggregate clearing member margin deposits.

Lehman's use of standby letters of credit

The SEC reports Lehman's 2007 annual report showing the firm's off-balance-sheet arrangements.

Off-Balance-Sheet Arrangements

... the following table summarizes our off-balance-sheet arrangements at November 30, 2007 and 2006 as follows:

...
Standby letters of credit. At November 30, 2007 and 2006, respectively, we had commitments under letters of credit issued by banks to counterparties for $1.7 billion and $2.4 billion. We are contingently liable for these letters of credit which are primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges.

Edgar-online reports that CME performance bonds and security deposits.

6. PERFORMANCE BONDS AND SECURITY DEPOSITS

CME [Chicago Mercantile Exchange] clears and guarantees the settlement of CME, CBOT and NYMEX contracts traded in their respective markets. In its guarantor role, CME has precisely equal and offsetting claims to and from clearing firms on opposite sides of each contract, standing as an intermediary on every contract cleared. Clearing firm positions are combined to create a single portfolio for each clearing firm's regulated and non-regulated accounts with CME for which performance bond and security deposit requirements are calculated. To the extent that funds are not otherwise available to CME to satisfy an obligation under the applicable contract, CME bears counterparty credit risk in the event that future market movements create conditions that could lead to clearing firms failing to meet their obligations to CME. CME reduces its exposure through a risk management program that includes initial and ongoing financial standards for designation as a clearing firm, initial and maintenance performance bond requirements and mandatory security deposits. Each clearing firm is required to deposit and maintain balances in the form of cash, U.S. Government securities, bank letters of credit or other approved investments to satisfy performance bond and security deposit requirements. All obligations and non-cash deposits are marked to market on a daily basis. Effective December 2008, the NYMEX performance bond and security deposit collateral has been fully integrated with the CME collateral portfolio. The NYMEX guarantee fund, which would have previously been used for any loss sustained by NYMEX due to the default of a clearing firm, was terminated, and NYMEX clearing firms have been included in the security deposit calculation.

In addition, the rules and regulations of CBOT require certain minimum financial requirements for delivery of physical commodities, maintenance of capital requirements and deposits on pending arbitration matters. To satisfy these requirements, CBOT clearing firms have deposited cash, U.S. Treasury securities and letters of credit.

...
In addition to cash and securities, irrevocable letters of credit may be used as performance bond deposits and security deposits. At December 31, these letters of credit, which are not included in the accompanying consolidated balance sheets, were as follows:

All cash, securities and letters of credit posted as performance bonds are only available to meet the financial obligations of that clearing firm to CME.

CMEgroup reports that collateral types accepted for deposit into trading accounts.

Collateral Types Accepted
...
Letters of Credit

Issued in the Exchange's name by approved banks.

Limited to combination use of letters of credit and government agencies of no more than 50% of clearing member's core performance bond requirement in excess of $5 million.

- Reserve requirements
- no limitation on the amount of letters credit

CMEgroup provides list of Approved Letter of Credit Banks.

Approved Letter of Credit Banks

If you wish to do business with CME Clearing, please consult the following list to find banks around the world that are approved for issuing letters of credit:

Should you have any questions, please contact Financial Operations at 312-207-2594

Jscc reports that clearing house acceptable margin.

H. Acceptable Margin

The eligibility criteria governing initial margin (variation margin is paid in cash) is an important aspect of a clearing house's risk management. The margin assets of a defaulting clearing member should be realizable in time to be used to meet the clearing house's own obligations and should therefore be (a) immediately available at all times and (b) relatively liquid i.e. convertible into cash.

So far as the first condition is concerned, worries have been expressed that letters of credit (LOCs), which have traditionally been accepted as an alternative to margin deposits, have a number of drawbacks. First, there is the risk of default by the issuing bank, in which case funds would not be fort hcoming. Second, there may be delays in completing the draw-down of LOCs: it has, for instance, been suggested that banks can take up to 3 days to honour such commitments,39 although much shorter time-frames can be agreed (see below). Finally, it is conceivable that a bank might decline to honour an LOC in a crisis. The CFTC has drawn attention to this last possibility when recommending that clearing houses "consider arrangements to reduce further the possibility that an issuing bank might attempt, during a crisis, to abrogate its obligations to perform immediately under an LOC".40

Such concerns have led the CFTC to require the phasing out of LOCs in futures clearing houses' guarantee funds (see below), while also encouraging reduced reliance on LOCs as initial margin. The CME now limits LOCs to 50% of a clearing members' total margin while the BOTCC imposes a limit of 25% of a clearing member's net capital. Both clearing houses require a one hour draw-down under the LOC agreement. In practice LOCs tend to constitute a relatively small proportion of margin collateral for the futures clearing house.41

The OCC has also sought to reduce reliance on LOCs so that between 1990 and 1994 LOCs fell from 57% to 36% of OCC total margin42. This decline was due in part to the lowering of "haircuts" on securities collateral (below), thereby encouraging a switch to securities margining. However, in contrast to the CME and BOTCC, the OCC allows a two-day draw-down period for LOCs on the grounds that the clearing house has adequate liquid resources to bridge the time gap.

41 For instance, the CME reported that as of March 1993, LOCs comprised less than 11% of total original margin: Intermarket Co-ordination Report, CFTC, May 1993, p. 63. As of March 1992, the equivalent figure for the BOTCC was approximately 15%: Intermarket Co-ordination Report, CFTC, May 1992, p. 55. By the end of 1997 the BOTCC's reliance on LOCs had fallen further to a mere 4% [It is still around 4% today].

My reaction: The standby letters of credit are a huge source of systematic risk and instability.

1) Banking legislation of the United States forbids US credit institutions from assuming guarantee obligations vis-à-vis third parties. To circumvent this rule, the US banks created the standby letter of credit

2) Standby letters of credit basically fulfil the same purpose as a guarantee.

3) Like all guarantees, standby letters of credit become worthless when issuing institution goes bankrupt.

4) To protect against clearing member defaults, OSS and CME required to deposit and maintain collateral balances in the form of cash, U.S. Government securities, and letters of credit.

5) Common sense says that the time standby letters of credit are needed (because clearing member defaults during a financial crisis) is likely to coincide with the time they become worthless (because clearing member bankruptcies during a financial crisis).

Standby Letters of Credit and 1987 market crash

Standby letters of credit totaled 57% of OCC total margin in 1990, and that percentage was undoubtedly even higher in 1987. This means that when the 1987 market crash began, banks were guaranteeing the vast majority of OCC settlement obligations at a time when most of the banking sector was already insolvent (see *****The Crisis in American Banking*****). This explains why regulators and the Fed intervened to stop the collapse: if they hadn't, most major banks, the ones issuing LOCs (see list above), would have gone under bringing down the entire financial system and the dollar.

Standby letters of credit today

Even if the use of standby letters of credit has declined, there are still widely used. CME standby letters of credit from the likes of Lehman Brothers totaled 3 billion in 2007.