Can Blockchain Revive the Letter of Credit?

By Ken Cottrill, Co-Founder and Research Principal ​​​​​​

  

​Traditional trade documents such as the Documentary Letter of Credit (LC) are in decline in cross-border commerce, so why are companies investing time and money in developing blockchain solutions that digitize them?
 
For example it was reported recently that global financial group BBVA used blockchain technology supplied by Wave to reduce the time taken to complete an international trade transaction from seven to 10 days to just 2.5 hours. The transaction involved the export of a shipment of tuna from Mexico to Spain, and payment was made using an LC issued by BBVA in Spain and processed by Bancomer in Mexico.
 
LCs have been around a long, long time. In international trade, an LC is basically a commitment by a bank on behalf of a buyer that payment will be made to the exporter provided that the terms and conditions are met, as verified through the presentation of all required documents.
 
The last phrase encapsulates the problems with LCs. The need to present documents to facilitate trade payments makes the process vulnerable to fraud and error. It’s also a relatively slow, expensive and unwieldy way to conduct business internationally. 
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Ocean shipping company Maersk estimates that the costs associated with trade documentation processing and administration represent up to one-fifth of the actual physical transportation costs. In 2014 Maersk looked at a simple shipment of refrigerated goods from East Africa to Europe, and found that the transaction involved some 30 people and organizations and more than 200 different interactions and communications between them.

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Such problems are not lost on companies that do cross-border business, and a growing number now use open account terms instead of LCs. It is estimated that 38% to 45% of the value of all traded goods and about 80% of transactions by volume, are conducted on open account terms[i].
 
An open account transaction in international trade is a sale where goods are shipped and delivered before payment is due, which is typically 30, 60 or 90 days. This option is advantageous to the importer in terms of cash flow and cost, but introduces more risk for the exporter.
 
There are ways to mitigate the risks inherent in open account transactions, and many come under the banner of Supply Chain Finance (SCF).
 
The Supply Chain Forum, a group of industry organizations including the ICC, has studied the development of SCF. “Supply Chain Finance is defined as the use of financing and risk mitigation practices and techniques to optimize the management of the working capital and liquidity invested in supply chain processes and transactions. SCF is typically applied to open account trade and is triggered by supply chain events. Visibility of the underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform,” says the Forum.
 
SCF will be the subject of a future Chain Business Insights Research Brief. For now, let’s get back to the stalwart of traditional trade finance, the LC, and, why it’s attracting interest in blockchain circles.
 
“With the majority of trade now conducted on open account terms, SCF is clearly the high-growth area in financing cross-border commerce,” says the International Chamber of Commerce in its 2017 Global Survey on Trade Finance and Supply Chain Finance 2017. The ICC received 255 responses from banks in 98 countries for its survey.
 
However, traditional trade finance remains key to an estimated $1.5 to 2 trillion in annual merchandise trade, estimates the ICC – a sizeable chunk of world trade.
“Traditional trade finance remains important and relevant despite the long-professed disappearance of the Documentary Letter of Credit,” says the organization.
 
Moreover, as the BBVA pilot project described above underlines, paper-based LCs are ripe for blockchain-based solutions.
 
Which begs the question: will blockchain technology halt the decline in the LC, or even trigger something of a renaissance in its use?
 
The answer is not clear cut at this stage. A renaissance seems unlikely given that traditional instruments such as LCs are still expected to decline in popularity or at least stagnate. In the ICC survey nearly 80% of respondents expressed the view that traditional trade finance will exhibit little or no growth, or decline.
 
However, can the same be said for digitized LCs? After all, blockchain solutions have the potential to speed up the documentary process and plug the security gaps that plague traditional trade documentation.
 
It’s an open question at this point, but a new survey from Chain Business Insights on trade finance will help to shed some light on the impact of blockchain technology on trade documents such as LCs.
 
The Chain Business Insights’ Opportunities for Blockchain in Trade Finance survey is open. Please complete the survey here.
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[i] Trade Finance Applications, CEB TowerGroup, August 2014.