The natural choice of fronting bank will be a bank which has already agreed (or is expected to agree) to advance senior debt to the Contractor. This bank will charge a fronting fee, equivalent to the credit margin it would normally charge on the swap were it providing both the swap and the credit cover. The fronting fee can be documented in a separate Swap Premium Agreement, and will be payable to the fronting bank at the same time as the swap payments, and in any case will cease to be payable upon expiry or earlier termination of the swap.
The back-to-back swap provider will be appointed by the Contractor on a competitive basis at Financial Close. The fronting bank itself may also bid against the market for the back-to-back swap. This procedure will be implemented by the Contractor and its advisers, and should be supervised by the Authority and its financial adviser.
Both the swap between the Contractor and the fronting bank, and the mirror swap between the fronting bank and the back-to-back swap provider, will be carried out using ISDA documentation.
The fronting fee should be taken into account in the initial bid and therefore not cause any subsequent changes in the Unitary Charge, unless the funding itself is subject to competition in which case the level of the fronting fee should be included in the terms for the competition.
If the back-to-back swap provider is an unconnected party, there is no reason why it should receive any additional protection against the credit risk on the fronting bank. However, the fronting bank may seek to be counter-guaranteed by other banks in a lending syndicate (if there is one).56 Any syndicate ank guarantee fees should also be reflected in the initial bid.57
If a syndicate counter-guarantee is not provided, the lenders will have to share their security with the swap provider (i.e. the fronting bank not its market counter-party), for which an inter-creditor agreement would be required, dealing also with issues such as voting and enforcement rights. Typically in such agreements the swap provider has no voting or enforcement rights unless there is a default on the underlying loan (or in payment on the swap)-to avoid the problem of how the swap provider's risk is to be weighted against that of the lenders-which is another reason why only banks involved in the lending syndicate are likely to be suitable fronting banks.58
The decision on whether to use the fronting bank arrangement for any hedging instruments needs to be taken prior to issue of the ITN. If this approach is adopted, the ITN will need to include details on the procedures to be adopted for appointment of fronting bank and back-to-back swap provider.
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56 The creditworthiness of the fronting bank may have some impact on the pricing of the back-to-back swap, as it would in the conventional situation where it simply provides an all-inclusive swap to the Contractor (if the swap involves a market counter-party). Similarly it might be argued that the fronting bank is taking additional credit exposure through the use of the back-to-back swap with the market, but in reality this is no different from the position under a conventional arrangement, except that it would normally hedge off the interest-rate exposure on a portfolio basis. The fronting arrangement is simply making explicit what is normally an internal risk management matter but the counter-party risks of this hedging by the bank are the same.
57 Unless there is to be a subsequent funding competition, in which case (as for the fronting fee this should be reflected in the terms of the competition.
58 for other reasons for this cf. §2.7.