Evolving the Letter of Credit in the digital age

Trade is a key component of global GDPs and trade finance is the lubricant that keeps the trade engine humming. According to the latest ICC Trade Survey, trade grew twice as fast as GDP before the global financial crisis, while in recent years it has been more in line with GDP growth.

Availability of trade risk mitigation and trade finance is a critical enabler of global trade in goods and services. In the ICC survey, Boston Consulting Group forecasts trade finance revenues to touch $48bn in the next three years.

Banks have traditionally played a critical part in keeping this engine of growth running perfectly, providing participants a range of solutions primarily around:

• Bridging the ‘trust’ deficit by being an independent third-party facilitator
• Providing risk mitigation
• Funding the working capital gaps by being a liquidity provider
• Settlement of transactions

The classic bank instrument which provides all of these services is the Letter of Credit, which revolutionized trade finance when it was born in medieval Europe and helped bring about the global trade order as we know it.

However, the primary strength of a Letter of Credit – the presence of a clear set of governing rules and precedents which clearly set out the roles and responsibilities of each party – is also its Achilles’ heel, as each party evidences performance through paper-based documents which result in manual paper-based processing, high operating costs and slow transaction delivery time for banks.

The products and services of tomorrow will be increasingly digital in nature with multiple parties across countries providing key data inputs at various stages of the cycle. In the past few years, cost and efficiency targets, as well as improvements in technology and analytics, have seen the emergence of non-bank intermediated trade, i.e. fintech and platform-driven open account trade and supply chain finance.

The products and services of tomorrow will be increasingly digital in nature with multiple parties across countries providing key data inputs at various stages of the cycle

Eliminating paper-based processes across the transaction initiation, evidencing supplier performance/shipment and settlement stages will be crucial to digitizing Letter of Credit-based trade flows.

So, is the Letter of Credit’s position as the go-to instrument for trade finance at threat of being disrupted?

The rest of this article explores this question and argues that the Letter of Credit is well positioned to morph itself into a product of the future. A new trade paradigm will emerge: combining the security and risk mitigation features of Letters of Credit with the cost and speed of open account and the visibility of a distributed ledger mechanism. In this new world, banks could be the super highways that facilitate this new trade risk mitigation and settlement mechanism across geographies.

However, before we get there, a few key issues around interoperability, electronic title transfer and legal enforceability need to be addressed before the industry can expect to see large-scale adoption.

According to the ICC, an estimated four billion pages of documents currently circulate in documentary trade. However, global Letter of Credit volumes have remained flat or fallen in the preceding years as counterparties gradually move away from Letters of Credit to open a/c trade.

As the world moves to increasingly data-driven trade and performance risk management, the billion-dollar question is: are the alternative platforms/procure to pay networks and technologies such as distributed ledger able to address the risks and requirements in any cross-border trade, in an efficient and scalable manner?

The Letter of Credit’s evolution will be powered by a few key trends which are occurring in the digital trade space today. Some of the notable ones are as below:

Digitization of goods title

The emergence of truly digitized title documents – electronic bills of lading, electronic warehouse receipts, electronic airway bills – has been a driver for early adopters as they seek to digitize their trade flows. However, in the absence of a universal set of rules on what comprises an electronic title document, this has been championed by closed-end ecosystems such as Bolero and essDocs, which provide a contractual mechanism to transfer title electronically.

In response to this gap and to address the current ‘digital island’ approach, we are now seeing progress towards a unifying set of rules to power this transition, such as:

• UNCITRAL Model law on Electronic Transferable Records adopted in July 2017
• ICC working groups looking to agree on a common set of standards for electronic title documents

The emergence of Distributed Ledger Technology (DLT):

The DLT revolution is a key driver which provides the necessary framework for designing and delivering the new products and solutions of the future, leveraging on the trends above and combining those with the salient features of the technology such as security, immutability and self-executing smart contracts.

However, the point to note is that Distributed Ledger Technology is simply that – technology. Though it provides a framework for trusted intermediaries to conduct business more efficiently, we do not foresee a transition wherein the role and obligation of banks can be replaced by a bunch of nodes which operate without regulatory scrutiny. Like any technology, we believe the onus is on the banks to leverage this architecture to deliver new solutions for their clients.

Bank/industry consortiums

Another key trend is the increasing cognizance among banks and other industry players – both global and regional – that they need to evolve to continue facilitating trade. As evidence of this changing dynamic, we have seen an emergence of trade consortiums, comprising banks and technology providers, which are looking to build an infrastructure layer leveraging emergent technologies to allow banks to design and deliver products of the future.

The last time we saw such concerted efforts from banks was in the payments space in the 1970s, and that resulted in the creation of SWIFT, which revolutionized the world of cash management and interbank communications.

The last time we saw such concerted efforts from banks was in the payments space in the 1970s, and that resulted in the creation of SWIFT

The core tenet of these trade consortiums – such as Marco Polo, Wilson, WeTrade or Voltron – is unification of trade through an open architecture even though their stated objectives and technology stacks may be divergent as of now. It is these attempts which will provide the required underlying brickwork to enable digitally initiated and accomplished trade transactions.

Data emerging as the new oil of B2B

The ongoing digital revolution has further put the spotlight on the unrivalled power of data-based analytics in achieving not only efficiency and dynamic risk management but pure business growth for all players in the trade ecosystem. Furthermore, we are increasingly seeing more and more regulators and government bodies join the digital revolution, which further provides a fillip to the ongoing digitization push – the EDPMS/IDPMS regime in India being a good example of a government using the power of data to ensure compliance with regulations.

In such an environment, the bulk of the participants in the trade cycle have a clear digitization strategy and/or a digitization roadmap to access the data underlying their business. This ranges from:

• Standard ERP systems to track procurement to payment cycles
• Internal treasury management systems for risk management and on-the-fly liquidity management
• Dynamic data solutions interlinked with Internet of Things-based devices to enable geo-location and quality assurance of goods and services
• Leveraging AI to automate banking roles such as document checking and identifying discrepancies

This internal retooling will allow parties to access data pools which will form the basis of digital interactions in the new economy.

Universal connectivity

The past few years have seen the emergence of many ‘digital islands’ – which aim to solve the problem of a lack of universal connectivity standards by creating trading ecosystems wherein each party simply needs to connect to a central infrastructure and post that can seamlessly transact with any other party in the ecosystem.

However, in the face of many such competing ecosystems, the need for unification is still relevant and this has resulted in the increasing focus on using APIs as well as attempts at interoperable distributed ledgers and adoption of Global Legal Entity Identifiers (GLEIDs).

Here’s what a potential ideal digital trade transaction flow could look like in future:

• Buyers and sellers agree on the necessary terms and conditions for a commercial trade on an online sourcing/front-end platform powered and delivered by their trade bank or by an online marketplace
• Buyers and sellers agree on and select the necessary counterparties who will need to provide relevant data to evidence performance under the agreed contract e.g. logistics provider, insurance, quality inspection, chamber of commerce etc.
• Title of goods will be controlled via digital title docs such as electronic bills of lading which are already prevalent, and status of the shipment will be available to all relevant parties linked to the transaction
• Banks may or may not be required as an independent third party to transfer digital title of goods/services in exchange for performance. This could be achieved through the translation of the above into a self-executing SMART contract which clearly specifies the data streams and sources which need to be available for the performance to be deemed complete and the buyer (or bank’s) payment obligation to crystallize
• Risk mitigation is provided by the platform and the SMART contract defining the obligations of the counterparties
• AI-based algorithms then use the data elements to auto-match the information from the data sets to the SMART contract requirements and once matched, would cause an execution of the SMART contract to crystallize the obligation/liability of the relevant parties in the chain
• Final settlement could happen via the banking channels and fiat currencies or using cryptocurrencies on the ledger without the need for a banking system

Issues to be addressed before large-scale adoption

Linking the above flow to the earlier key benefits provided by a Letter of Credit in the current world, here are the questions that need to be addressed before we see any serious adoption of digital alternatives to Letters of Credit:

• Large-scale adoption of the UNCITRAL model law for electronic title documents /transfers
• What happens when something goes wrong in this digital SMART contract-based transaction? E-laws vs. contract laws; does the affected party sue all the nodes in the chain? How do you challenge a SMART contract in a court of law? Will standard SMART contract/e-rules develop globally and be adopted by countries similar to the evolution of UCP rules?
• Who owns the data? Who is responsible for the accuracy of data provided digitally for such SMART contract-based execution? Is it the data provider or is there any obligation on the infrastructure provider? Pan country data confidentiality rules need to evolve to enable client and transaction data sharing between counterparties
• Will there be a universally acceptable global legal entity identifier/certificate to uniquely identify counterparties across different cloud and DLT platforms? Will this allow passporting between these platforms as the current closed loop digital islands are not sustainable or scalable with different contracts, standards and sign-on processes
• Who is responsible for ensuring compliance with the law of the land? As an infrastructure provider, are the banks still liable for AML/Sanctions compliance when they are simply providing the connectivity layer for corporates but not financing the underlying transactions?
• Finally, who will be responsible for constructing the common open standard which is required for allowing unification in this space?

The eventual answers to these questions will determine both the scope and pace of transformation which will engulf the world of trade finance and morphing of the Letter of Credit into viable digital alternatives. These may then provide the same or better level of control of title of goods, counterparty risk mitigation, settlement and financing, and at the same time deliver these much more efficiently across cost, space and time.

A new era for trade?

In summary, we live in exciting times when different families of technologies are coming together to redefine business models across sectors – the so-called Fourth Industrial Revolution or Industry 4.0.

It’s no longer a question of whether change will come, but rather how fast it will arrive. The future is all about data and data-based risk mitigation and financing. The paper-based performance evidencing, as well the good old Letter of Credit may be disrupted eventually. However, the industry needs to collectively solve the key questions raised above (and more).

Only then will alternative scalable digital solutions emerge to address client primary needs – control of cross-border title of goods, risk mitigation, settlements, etc. with a fully developed legal framework that makes it much simpler and more efficient to do business.

Letters of Credit may eventually dwindle but the underlying benefits they provide will live on in the digital paradigm in a different avatar which is yet to come into being.

Samuel Mathew is global head of documentary trade, product management and transaction banking at Standard Chartered Bank.