Steps to a blockchain-based letter of credit transaction
In international trade, the letter of credit is hard to imagine without as a hedging instrument. But something has already come into the day. Not least because of the still exclusive use of paper documents, it is slow and expensive to process. Innovative blockchain technology could modernize the letter of credit.
International trade has always been associated with risks. And traders have been protecting themselves with insurance and other instruments for centuries. The letter of credit also has a permanent place among payment protection instruments.
In its original form as a letter of credit
It served traders as a safe alternative to physical gold. Because only they could get real means of payment from banks. In the 20th century, the current functioning of the letter of credit crystallized.
It is the promise of payment from an importer’s bank to the exporter. The exporter, therefore, has the security of receiving the payment due from the bank if he submits the agreed export documents as evidence of the dispatch of the goods.
The letter of credit itself sets out the conditions that the exporter’s documents must meet. The bank checks the physical documents for conformity with the conditions of the letter of credit and then initiates the payment. Almost nothing has changed in this way of functioning in recent decades.
Bring the letter of credit into the 21st century
Documents are no longer checked, but only data records are compared. This is done on a central application that receives, processes, and decides on conformity.
This is actually faster and cheaper than processing by letter of credit. But since only records are compared, the BPO is also less secure.
So what if you could digitize the letter of credit yourself? But with a decentralized, counterfeit-proof technology like the blockchain? The dispatch and processing of physical documents could thus be omitted – and with almost the same level of security.
The blockchain letter of credit
The main difference to the classic letter of credit would be that digital copies of the export documents are stored unchangeably in a private blockchain (instead of being physically sent by courier). This would not only make them immediately accessible to the next responsible party. At the same time, it could always be verified beyond doubt that these are actually the copies uploaded by the exporter.
By using smart contracts, any complex processes could be processed partially or fully automatically in the future. All parties involved would be informed about the processing status in real-time and could carry out the necessary processing steps themselves.
And as soon as not only the importer, exporter and their banks were involved in the transaction, but also, for example, transport companies next, the security and speed of processing would increase again.
Steps – reminiscent of the classic letter of credit
Based on the process of a classic letter of credit transaction, a blockchain-based transaction would, for example, be processed in the following eleven steps.
- The importer creates a private application for a blockchain letter of credit (BC-LC) on the blockchain with the conditions agreed in the delivery contract. He releases the BC-LC to his bank.
- The importer’s bank receives the BC-LC request and decides whether it will be implemented. In the positive case, the BC-LC is actually opened or the request is rejected.
- The exporter’s bank has access to the BC-LC and decides whether it will handle the settlement. In the positive case, it sets up access to the BC-LC application for the exporter.
- The exporter can check the BC-LC. If he does not agree with certain conditions, he can return this to the importer in the opposite way. Otherwise, the BC-LC is considered opened and advised.
- The exporter delivers the goods as described in the BC-LC.
- For example, it uploads invoice and delivery data to the blockchain and also attaches copies of all relevant documents.
- The data is (partially) automatically compared with the conditions of the letter of credit. The bank of the exporter also checks the uploaded documents and informs the bank of the importer if the letter of credit is compliant.
- The digital documents are checked again by the importer’s bank. If discrepancies are still discovered, the bank marks them for the importer in the blockchain documents.
- If the letter of credit conforms, the payment is triggered immediately. If there are any discrepancies, the importer receives access to the marked documents from his bank and decides whether to release the payment and reject the documents.
- If the payment is released, it will be sent to the exporter’s bank and credited directly to the customer.
- Finally, the importer receives the goods.