Blockchain For Letter Of Credit

By Sachin Sawashe on ALTCOIN MAGAZINE

Abstract

This page briefly analyses usage of Letter of Credit in international trade, current standards, possible risks, and its shortcoming. The document also puts forward a solution for various risks involved and make the process faster, transparent and safe.

Photo by VanveenJF on Unsplash

Introduction

World merchandise exports totaled US$ 19.48 trillion in 2018. Import and Export the major pillars for international trade have been using Documentary Credit or Letter of Credit (LC) since 19 century and counts to around 12–15% of international trade. LC guarantee to seller/exporter of getting the pre-agreed price for his goods and at the same time assures buyer/importer of getting the right goods at right time. The risk is mitigated by using banks as intermediaries.

ICC (International Chamber of Commerce) established Uniform Customs and Practice for Documentary Credits (UCP 600) as a set of rules on the issuance and use of LC. With the advent of electronic message transmission banks started using SWIFT (Society of Worldwide Interbank Financial Telecommunication) which by and large established a standard format for LC with its MT 700 series.

A typical LC transaction The below figure shows involved stakeholders and sequential steps involved to carry out a complete LC transaction.

Limitation of LC

1. Bank Fees: A letter of credit adds to the cost of doing business. Banks charge a fee for providing this service, and it can increase steeply if the parties want to put some additional features. This becomes a major hurdle for small and medium importers and exporters.
2. Messaging Fees: Most banks use SWIFT network for exchanging messages which charge based on the message type, data, and volume of messages. Any amendment in the original message is also costly and time-consuming.
3. Payment Disputes Due To Contractual Ambiguities: Interpreting the semantic ambiguities of the legal clauses in the LC contract usually necessitates discretionary determination by the bank. An ICC study indicates that between 60% and 70% of documents presented for LC evaluation are rejected on the first presentation due to such discrepancies.
4. Possibility of Misuse: A letter of credit poses a material fraud risk to the importer. The bank will pay the exporter upon looking at the shipping documents and not the actual quality of goods. Disputes can arise if the quality is different from what was agreed upon.
5. Currency Risk: A letter of credit also carries forex risk. There will be an agreed-upon currency in the letter of credit. At least one of the parties will have a different currency than that, and hence they will face risk due to currency fluctuations. It can also work in favor.

A Blockchain Solution

Using federated blockchain, an LC can be modeled as a smart contract between the importer and exporter to guarantee payment to the latter, if the trade merchandise is delivered to the importer in accordance with all specified conditions.

Letter of credit is issued on Distributed ledger technology network consisting of the exporter, importer, issuing bank, advising bank and may be even the transporter.

1. The LC terms and conditions can be drawn by the importer and stored immutably on the blockchain network as a draft.

2. The draft is presented to issuing bank which after review will approve it.

3. The draft can also be reviewed by the exporter and approved by his advising bank.

4. The Network consensus ensures that there exist only one copy of LC and all parties can work on it depending on their access rights.

5. Once reviewed and approved by all parties, Issuing bank finalizes the LC and issues it to the exporter.

6. Any changes/amendment can be implemented using multi-signatory mechanism by granting appropriate permissions to participants. The blockchain smart contract contains terms and condition of trade.

The contract expresses condition clauses like

a. The Date of delivery

b. Port of delivery

c. Packaging and Handling

d. Transport mode

e. Bill of Lading

f Customs clauses

g. Quality and Quantity certificates

Finally based on documentary evidence submitted by the exporter, verification of conditions stated in LC can be evaluated.

Advantages

1. LC requirement are documented in a smart contract which exactness and precision on the contractual conditions like time and place of delivery, mode of delivery and quality of the product.
2. It allows for more transparency around transactions and operations, including everything from tracking invoices to digitizing documents.
3. The issuing bank can verify condition on the basis of documented submitted by exporter/advising bank effectively removing ambiguity.
4. All stakeholders have visibility of the latest state and any discrepancies can be resolved faster.
5. Any change/amendment can be processed faster and in cost-effective way through a multi-signatory mechanism.

Who All And How In Industry Exploring Blockchain

Distributed ledgers are business-to-business workflow tools, which entails that blockchain practically demands collaboration — to set standards, develop infrastructure, and execute transactions. Consortia are the mechanism through which blockchain-interested companies, regulators, and governments are collaborating.

Consortia have become a popular means for enterprises to work together on blockchain technology. There are two types of blockchain consortia business-focused and technology-focused.

A) Business-focused consortia aim to build and operate blockchain-based business platforms to solve a specific business problem. Example Voltron and Marcopolo which uses R3’s Corda blockchain to carry financial trading. Bita is a blockchain association for the transport industry.

B) Technology-focused consortia seek to develop reusable blockchain platforms based on technical standards. An example is Hyperledger. Hyperledger is an umbrella project of open-source blockchains by the Linux Foundation and has received contributions from IBM, Intel, and SAP Ariba, to support the collaborative development of blockchain-based distributed ledgers.

The project has famous platforms like fabric, burrow, indy, and tools like composer, explorer, cello to name a few.

Below figure gives a list few of consortium and there supporting partners in trade finance.

Courtesy : https://www.cbinsights.com/research/banks-regulators-trade-finance

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