Letters of credit: disappearing or evolving?

A second wave of digitalisation enabled by digital ledger technology (DLT) is set to abstract age-old pain-points from trade finance.

Currently accounting for approximately 13 per cent of global trade finance, the letter of credit (L/C) has been losing ground for a long time. It is the most secure, albeit rather cumbersome and costly, way of guaranteeing for the exporter that they get paid by the buyer for the consignment they have dispatched. But its paper-based form is prone to error and fraud – it is estimated that 80 per cent of L/Cs have discrepancies when presented to banks.

An alternative exporters can and do turn to is open accounts. Although they provide no guarantees, combined with established forms of trade finance such as factoring and forfeiting, open accounts can ease cashflow and liquidity problems – at some cost. But how come we still don’t have some fast and efficient digital tool to address the trust problem L/C was the original solution to?

One attempt at just that was bank payment obligations (BPOs), a hybrid of L/Cs and open accounts. Unlike in L/C arrangements, with BPOs documents are exchanged between the exporter and the importer without the inclusion of their banks. Moreover, the so-called transaction-matching – the checking of the purchase order against the invoice to see whether the two tally and the process can go ahead – is automated. Both features work towards accelerating the transaction.

BPOs, however, never took off, and will be decommissioned later this year. But the core concept of making an irrevocable-but-conditional payment obligation will live on in state-of-the-art trade payment solutions powered by blockchain.

Blockchain: not fit for trade finance purposes?

There is a lot of talk nowadays about blockchain being the panacea for the woes of many late-adopter verticals, but on closer scrutiny it turns out that, more often than not, the types of DLT that come to the rescue are neither public nor are they constituted of blocks.

In a public distributed ledger such as the blockchain, every node has a record of all the transactions that have taken place within the network. In trade payment, however, partners don’t want to share the immutable record of their deal across nodes that weren’t involved in it. All you need the nodes for is the verification of documents and bearing witness to the commitment to pay once conditions are met.

Therefore, leading DLT platforms such as Quorum, Hyperledger Fabric and Corda, have introduced different types of privacy controls to contain a public database, as well as private ones. Either the nodes are programmed to execute contracts only if they are parties to that particular deal, or the architecture of the ledger sets up a separate channel for each transaction with a ledger of its own.

These networks are always permissioned – organisations need to get authorisation to join them. But rather than being owned by a single organisation, they are governed by consortia of banks, trading partners and corporates, thus preserving more of the multiplayer trust mechanism of the original blockchain than their private counterpart would.

They still have distributed data storage and verification at their heart, but to ensure ease-of-use, speed and low energy consumption, they needed to break with the blockchain and its unique features, mining and trust by maths. Instead, they rely on alternative consensus mechanisms such as majority voting.

Digital finance platforms and letters of credit

Will new digital trade finance platforms give the letter of credit a new lease of life or put an end to it?

It’s still too early to say whether emerging distributed ledger technology is going to perpetuate or replace the old ways of payment guarantees. WePay, one consortia with a focus on open account trade finance, and in operation for more than a year now, has no L/C offering. Another, Komgo, has already issued thousands of digital L/Cs in the first year after going into production. Contour, formerly known as Volton, an HSBC initiative, was set up with the mission of creating a letter of credit blockchain platform to cut the five-to-ten-day execution process to 24 hours.

Meanwhile, Marco Polo, an extensive network that can be integrated into corporate ERP systems, combines the L/C with the best features of the withdrawn BPO system, creating a proprietary payment commitment solution. As a conditional payment mechanism, it is based on the irrevocable payment undertaking of the buyer’s bank to the seller’s bank, triggered by the matching of trade data.

Having different profiles with some overlaps, these consortia may develop in separate directions, offering complementary services. But there are already some signs of consolidation within the industry. WePay, for example, has already connected its platform with the Hong Kong Monetary Authority (HKMA)’s eTradeConnect, establishing a trade finance corridor between Europe and Asia. HSBC, the bank behind Contour, completed its first trade financing transaction on WeTrade last August. However, it remains to be seen whether the direction of travel is towards fully digitalising the L/C trust mechanism or coming up with new, digital-native solutions, which will eventually consign it to oblivion.

© Business Reporter 2020