As of now, the trade finance industry is rather sloppy, especially with regard to its lengthy processing time. The primary function of the trade finance industry is providing finances to businesses, both at the local and global levels.
In doing so, the industry provides various services like lending, transferring letter of credits, providing insurance, among other things. Out of these many phases of financing, the production and transfer of a letter of credits are by far the lengthiest.
Letter of Credits
Basically, letter of credits is a document which is used to establish trust while carrying out cross-border financial transactions. At times, letter of credits may also be referred to as ‘Documentary Trade’.
Primarily letter of credits or LC acts as a bond. They guarantee payments between parties undertaking business across national borders. In general, the issuing authority of an LC is the bank to which the buyer requests the same.
Through the LC, the buyer promises to pay a certain amount when the payee meets certain pre-defined terms of the contract. The bank, in turn, acts as the guarantor and ensures that any possibility of fraud is ruled out.
The significance of the LC lies in the fact that the cross-border parties mostly don’t know each other in person. So, it is essential that they have an official bond of trust or the LC. As is evident from above, the LC plays a pivotal role in the overall functioning of the trade finance industry.
In fact, it is one of the most common services provided by the industry. However, despite all that, the processing of LC is by far the most tedious and lengthy phase of trade financing.
Present Issues with Letter of Credits
As of now, a majority of the process of LC production is undertaken manually, making the process winding and strenuous. The issuing of a letter of credits is a complicated process as it involves many different parties and stakeholders.
For instance, exporters, importers, banks, shipping authorities, customs, and others interact to issue a single LC. Moreover, the process involves a great number of legalities which have to be established before issuing a letter of credits. The manual processing of all these nuanced steps of the issuing of the LC gives rise to many problems.
- First, the process becomes much longer than it could have been otherwise.
- Second, the overall functioning of the trade finance industry has been much inefficient due to its manual functioning.
- Third, manual production of such huge quantities of documents often leads to errors which ultimately affect the involved parties.
- Fourth, when documents are produced manually, chances of them being manipulated are high. Thus, the trade finance industry has been vulnerable to fraud and other security compromises.
- Fifth, the process involves the functioning of multiple intermediaries, which, ultimately leads to a cost escalation.
In this context, many have argued that complete automation of the process is of utmost importance. It is being proposed that the trade finance industry implements the hyper-ledger fabric, enabled by blockchain.
Blockchain as a Solution
In many different ways, blockchain can significantly enhance the issuing process of the letter of credits. In fact, “smart contracts”, enabled by blockchain are advanced, digitized versions of the letter of credits.
Primarily, the application of blockchain in the issue of LC can make the process much more secure and transparent. As the information stored on a blockchain is indelible, it virtually rules out the possibilities of document forgery and fraud.
Every part of information on a blockchain is linked to another and they can be accessed only in relation to one another. This enhances the traceability of the entire process of issuing LC.
Moreover, the application of blockchain automation significantly brings down the overall process cost. It’s rather needless to say that all this enhances the efficiency with which an LC is issued. Most importantly, apart from anything else, blockchain-based LC production would lead to a massive decrease in the processing time.
In the following section, let us take a step-by-step look at how a blockchain-based LC can be produced.
Steps in LC Production using Blockchain
- The buyer initiates an application for LC and stores it on a blockchain for review by the bank.
- Once the bank receives the request for review, it may either accept or decline the LC, based on the blockchain’s data.
- On the approval of the importer’s bank, the exporter’s bank is automatically given access to the blockchain. The institution reviews the information provided and decides accordingly.
- After the approval of its bank, the exporter gains access to the blockchain information. He/she reviews the terms and adds his/her own terms on the blockchain.
- Through processes similar to steps II, II & IV, the LC comes back to the importer. If the importer has no issues, the LC status is updated as completed. In case of discrepancies, the LC has to again go through these steps.