Letters of credit (LC) are the most widely used payment settlement method in global trade. However, their value can be seriously limited by the risks and inefficiencies in the current process, which have increased the time and cost of LC issuance and verification. Such delays and overhead have made the LC process less attractive for trading parties, especially for low-value transactions, and have contributed to the rise of open account trade, which disintermediates banks from the process.
The biggest LC inefficiencies stem from three sources: contractual ambiguities, contractual errors and amendments, which result in disputes; delays from contract errors; and additional costs and overhead from amendments (see below).
A Blockchain Solution
Blockchain technology can eliminate these inefficiencies. Using blockchain, an LC can be modeled as a smart contract between the financier and the supplier to guarantee payment if all conditions are met.
A blockchain smart contract codifies the terms and conditions of trade. This is done by abstracting and expressing conditional clauses as separate, independent or interdependent functions that provide pass/fail outputs based on the input information. Program logic can be used to automatically evaluate and verify that LC conditions meet specified shipment deadlines and indicate compliance or non-compliance.
The LC is issued on a distributed ledger technology (DLT) network consisting of buyer, seller, facilitating banks and other trade finance entities acting as participating nodes. The LC terms and conditions can be drawn by the importer and stored immutably on the blockchain network as a draft. This draft is first made visible to the issuing bank, which, after reviewing and underwriting the LC application, can digitally sign it to confirm its approval.
Similarly, the LC can be sequentially reviewed and approved by other participating banks, including the advising bank, before being forwarded to the exporter. The network consensus mechanism ensures there is only one single final version of the LC draft at any given time and that all parties are able to view and work on this version based on their access rights.
After being reviewed and accepted by the exporter, the LC is finalized as a contract between the issuing bank and the exporter. Amendments or updates can be managed through a similar multi-signatory mechanism, providing approval and viewing permissions to buyer, seller and participant banks based on the nature of the required change.
This approach can result in three main benefits:
Reduced contractual ambiguities.
Specifying LC requirements as logical and verifiable conditions in the smart contract-based template compels exactness and precision regarding time, place, value and manner of shipment while drafting the LC. For example, phrases like “beginning of the month” and “as soon as” are replaced by discrete date and time ranges to clearly specify the allowed dates for shipment, delivery, payment, etc. Through smart contracts, each condition can be evaluated based on the documents submitted by the exporter, effectively removing ambiguities and, consequently, the need for discretion by the issuing bank.
Also, by modeling the preceding sales contract between the buyer and seller as smart contracts, as well as the agreement between the buyer and the issuing bank, data discrepancies can be further prevented in the LC contract, as key data elements such as goods description, parties’ names, etc. can be picked up directly from the underlying contract.
Early discovery of information discrepancies.
Since all trading and facilitating parties also have visibility into the LC issuance process on blockchain — and clear oversight into the current status of the pending actions — potential discrepancies can be more quickly identified. Moreover, any required amendments or corrections can also be conducted earlier in the process rather than after presentment to the issuing bank. For example, if the shipment is delayed by a couple of weeks, the implications can be dealt with in real-time; discussions can be initiated and decisions made ahead of presentment instead of after the discrepant documents are rejected by the issuing bank. This will help to reduce the time taken for bank evaluation and also speed delivery, freeing funds for the seller’s working capital needs.
Reduced time and cost of amendments.
Through the multi-signatory mechanism, any changes required can be instantly approved or countered by the relevant parties, with the updates visible to all stakeholders in real-time. This approach substantially reduces the time taken to issue and update an LC. Proofs of concept (PoC) for LC automation via smart contracts have reduced execution times from weeks and days to a few hours.
By effectively dealing with their pain points, blockchain holds the potential to make trade finance payment methods more efficient, reliable and profitable for all trading parties and increase their indispensability for risk mitigation in international trade.
For the full report, please see “Blockchain for Trade Finance: Payment Method Automation (Part 2)” or the first in our series, “How Blockchain Can Revitalize Trade Finance (Part 1).” You can also visit us at our Blockchain & Distributed Ledger Practice website.