Welcome! The Letters of Credit in Blockchain Technology.

“15 Indian banks form blockchain trade finance consortium”

The headline was attention grabber. It was one of the best pieces of news from Indian Banking sector that came to my notice while reading the content on the internet.

Why?

Being a finance person, I have seen the countless ways De-Fi addresses the poor and inequalities of the traditional financial set up that we still operate with. I believe there is great opportunity for traditional and neo-banks to get together and implement Blockchain technology to support their existing framework. Particularly, it will bring a tremendous change in the developing countries in general and specially in the banking sector in India.

It so happened, that just one week earlier, it’s by coincidence, on the topic of Blockchain technology and its applications, in the De-Fi space, I was talking about it to Nikhil, the CEO, aPitchDeck.com, wherein I mentioned, why banks were lagging behind in making use of this technology for the instruments like Letters of Credit, Letters of Guarantee and Bills Discounting and Factoring.

Usage of Blockchain technology is best suited and adaptable in the De-Fi finance in the present digital banking space. A letter of credit has complex governing rules that makes every bank to be cautious and create tough internal rules and regulations as some notorious buyers or sellers can misuse it to take advantage of it. A letter of credit can pose a material fraud risk to the importer. The bank pays the exporter upon looking at the shipping documents and on many occasions not actually looking at the quality or the physical quantity of the goods being shipped.

Letters of Credit is also referred to as a documentary credit. It acts as a promissory note from a Bank. It guarantees a buyer's payment to a seller or a borrower's payment to a lender will be received on time and for the full amount. They are issued by banks to ensure payment for goods shipped or the services rendered in connection with international trade. Payment on a letter of credit generally requires that the paying bank receive documentation certifying that the goods ordered have been shipped and are en route to their intended destination. 
The process of issuance of Letters of credit is complex and requires experienced staff who possess a certain amount of trade finance knowledge as well as an experience.

Conventional Method of issuing Letters of Credit.

The conventional and traditional method of Letters of credit used to be on a standard form or a typed document on the official Banks letterheads, duly stamped and signed by the authorised Managers, whose signatures were also conveyed to the corresponding banks. Four decades ago,during my banking tenure and employment days in the Middle East at Abu Dhabi, I worked with the erstwhile Banque de Paris et Des Pays Bas, that went to become Banque Paribas and later became BNP Paribas.

Letters of Credit, Letters of Guarantee and Bills Discounting were the instruments used by the banque to generate handsome revenue in the gulf states. Almost all the foreign banks had L/C, L/G, Bills Discounting and Factoring divisions in their branches and raked in moolah from the booming petro dollar economies of the arab states. Entire process was handled manually. Several Letters of Credit instruments used to have at least one or the other technical issue that would delay the payments or the shipments depending upon the issue on the Letters of Credit issued.

Application of Blockchain to Letter of Credit

Using Blockchain technology can help streamline the manual processing of letters of credit and letters of guarantee. There will not be misunderstanding between bank officials from both ends, confusing over the terms and conditions contained in the documents. The complexities of import and export documentation would improve. The chances of manual errors would almost cease. That will make companies' working capital more predictable and increase convenience for all parties through mobile interaction. The payment execution methods in the underlying trade contracts can be modeled as smart contracts on a Blockchain to provide payment certainty to the seller. It could be swift and without any delays.

There are several instances in the international trade space, where the Letters of credit fraud are often attempted against banks by providing false documentation to show that goods were shipped when, in fact, no goods or inferior goods were shipped. That’s where the smart contracts would come in handy for the financial institutions, wherein no duplication of the documents could be created to defraud them.

The nodes of the Blockchain store copies of the smart contract that can be shared public ledger. It records the transactions that are approved and verified. There are no chances of any errors or alteration of data once it is recorded. Hence, it can become automatically irrevocable.

I wish and hope, these banks will include the other instruments such as Letters of Bank Guarantees and Bills discounting as well. With instruments such as Tender Bonds or the Performance Guarantees as well as Advance Payment Guarantees, once converted to smart 
contracts, will ease a lot of pressure from the Banks and streamline the banking procedures.
Conclusion:

Banks normally take more than two business days to provide Letters of guaranteeing payment by the confirming branch. With the blockchain, it can be processed and issued within a matter of hours.

Similarly, the Bills discounting and Factoring must be brought under the Blockchain technology fold. Bills discounting is the practice of using a company's unpaid invoices to raise working capital for ease of cash flow for improving its day to day operations. Traditionally, financial institutions including banks and NBFCs have been discounting invoices for MSMEs.

Bringing bills, invoices under Blockchain and adoption of smart contract strategy, will open up the venue for small to medium size traders to seek an alternative capital instead of pledging their assets or other capital goods.

C

Blockchain is not the technology of tomorrow. It is the technology of today and hence the adaptation of blockchain technology in these banking financial instruments, will help the import export industry tremendously. Presently both, exporters and importers have to pay high fees when choosing the letter of credit as a payment option. These costs will be substantially lowered due to digitization and adoption of Blockchain Technology.

Raticanta Mandrencar.