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Revolutionizing Trade Finance with Blockchain: tokenization of Letters of Credit
Andrea Frosinini
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10 min read · Dec 16, 2023--
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In the realm of global trade finance, the emergence of blockchain technology has introduced transformative possibilities, particularly in the tokenization of letters of credit (LCs). This innovative approach aims to digitalize and streamline traditional LC processes, offering efficiency, transparency, and security to global trade transactions.
In the realm of global trade finance, the emergence of blockchain technology has introduced transformative possibilities, particularly in the tokenization of letters of credit (LCs). This innovative approach aims to digitalize and streamline traditional LC processes, offering efficiency, transparency, and security to global trade transactions.
What Tokenization Entails.
Digital Representation: Tokenization allows for fractional ownership and simplifies the buying, selling and transferring of these assets on a blockchain network.
The use of blockchain technology ensures that every transaction is recorded, providing a trustworthy and tamper-proof record. Tokens are designed to be interoperable, meaning they can easily interact and exchange data or values across different platforms. This interoperability significantly enhances the utility and potential applications of tokenized assets.
Benefits of Tokenization.
Tokenization allows fractional ownership, enabling more individuals to invest in assets that were previously illiquid or inaccessible due to parameters like high risk and capital in those markets. Tokens can be traded globally without geographical restrictions, facilitating continuous trading across different time zones. Blockchain’s use of cryptography to conceal data ensures secure and tamper-proof transactions, reducing the risk of fraud and unauthorized alterations. Finally, tokenization reduces administrative costs associated with traditional asset transfers, making transactions more cost-effective.
Challenges of Tokenization.
Regulatory uncertainty is indeed an issue. Legal and regulatory frameworks around tokenized assets are evolving, posing challenges in compliance and jurisdictional issues. As for the perception and adoption, traditional investors or stakeholders might be hesitant to embrace tokenized assets due to unfamiliarity or mistrust in digital assets. Tokenization offers promising solutions to long-standing issues in asset ownership, trade, and accessibility. However, addressing regulatory, security, and adoption challenges is crucial for its widespread acceptance and seamless integration into various industries.
Understanding Tokenization of Letters of Credit.
Tokenization transforms physical assets or rights into digital tokens within a blockchain framework. When applied to letters of credit (LCs), this process converts the traditional LCs into digital, programmable tokens on a blockchain network. These digital tokens embody all the specific terms, conditions, and obligations associated with the LC, ensuring that each transaction is secure and efficient. This digital representation on a blockchain not only enhances the security and transparency of trade transactions but also streamlines the process, making it more agile and responsive to modern trade demands.
Understanding Challenges of Traditional Letters of Credit.
Letters of CreditTraditional LCs often involve complex and slow-moving processes, characterized by extensive paperwork and manual handling. This inefficiency is further compounded by high courier costs. The current system of trade is a multi-window process which is very slow and cumbersome. A recent report by the ICC states that
a typical trade transaction involves up to 27 documents, 9 of which relate to the transfer of possession, and can cost up to $80,000 per transaction. This process can take up to 2–3 months to complete.
In total, 4 billion documents are traded at any given time in the trade ecosystem. Establishing LCs without existing banking relationships can be challenging, impacting the smooth processing of transactions and creating more delays to begin trade transactions. According to another ICC report, 55% of banks state processing a letter of credit could take over 20 days (about 3 weeks) to process.
The current process of producing and transferring traditional LCs leads to a lack of transparency and traceability. This makes it difficult to accurately reflect current market rates and further increases the likelihood of incoming error. Errors in document creation are common, leading to potential disputes and delays. Inexperienced document checkers and high first-time refusal rates from issuing banks, mainly dealing with SMEs, will further increase the finance gap.
Problems with Letters of Credit
UPDATED 2023] There are a number of difficulties with using a Letter of Credit, but they are one of the most widely…
www.tradefinanceglobal.com
Traditional LCs are vulnerable to security issues, including the risk of document duplication and documents being altered. The lack of secure and immutable systems makes traditional LCs more susceptible to fraud and errors. The creation of LC’s lacks the automated compliance provided by smart contracts in tokenized LCs.
The diverse range of regulations across different countries adds complexity to traditional LC transactions, particularly in cross-border dealings. Sanctions and lack of agreements between countries can hinder LC processes. The largely paper-based verification process, despite existing SWIFT standards, leads to potential delays and fraud risks. The absence of a global standard for party identification, like the Legal Entity Identifier (LEI) system which only accounted for 4% of UK companies in 2021. Further usage of the LEI creates trust and security issues, impacting global accessibility and efficiency.
Electronic Letters of Credit
What is an Electronic Letter of Credit? An electronic letter of credit can be defined as a letter of credit…
www.letterofcredit.biz
Understanding Tokenization of Letters of Credit
Tokenization transforms physical assets or rights into digital tokens within a blockchain framework. When applied to letters of credit (LCs), this process converts the traditional LCs into digital, programmable tokens on a blockchain network. These digital tokens embody all the specific terms, conditions, and obligations associated with the LC, ensuring that each transaction is secure and efficient. This digital representation on a blockchain not only enhances the security and transparency of trade transactions but also streamlines the process, making it more agile and responsive to modern trade demands.
Key Advantages of Tokenized Letters of Credit
Tokenizing LCs significantly reduces the cumbersome paperwork and manual processes traditionally associated with LCs. This digital approach streamlines the entire process, from issuance to negotiation and settlement, thereby expediting trade transactions. The speed and efficiency gained here are key advantages, making the trade process more agile and responsive to market demands. The physical transfer of a Letter of Credit can take up to 5 to 10 days (about 1 and a half weeks) from the invoice generation to finally reach the bank. A tokenized LC can be processed in a few hours according to Oracle .
Presentation under a Letter of Credit issued on the blockchainThe use of blockchain technology plays a crucial role in enhancing transparency and traceability. Since blockchain offers an immutable ledger, every transaction and step in the lifecycle of a tokenized LC is securely recorded and traceable. This aspect greatly reduces discrepancies and disputes, as every party involved can access a reliable and unalterable record of transactions.
Presentation under a Letter of Credit issued on the blockchainThe cryptographic nature of blockchain technology ensures a high level of integrity and security for tokenized LCs. Moreover, the incorporation of smart contracts automates compliance with predetermined terms, significantly reducing the risk of fraud or errors. This automated, secure environment builds trust and reliability in the system.
Tokenization then removes geographical barriers, enabling borderless transactions and facilitating global trade. This is beneficial for the global economy, where accessibility and efficiency are lacking with the current system. Technology enables various stakeholders in the trade ecosystem to engage in transactions seamlessly, regardless of their physical location. According to a ICC report for SMEs, 60% said Digital Letters of Credit or eBills of Lading would improve working capital Management. This is important because Working Capital is the most common form of trade finance, behind letters of credit.
Digitalizing the process of issuing and transferring letters of credit can greatly reduce the cost of conducting global or domestic trade. Utilizing paperless trade will cut 50% of the trade finance gap, allowing SME’s and smaller businesses to participate in global trade .
Practical Use Cases of Tokenized Letters of Credit
Tokenized LCs streamline international transactions, offering secure and transparent dealings across various countries, simplifying processes for buyers and sellers.
They integrate into supply chain finance systems, improving liquidity and capital management for global trading businesses.
Digital platforms using tokenized LCs create efficient marketplaces for interaction among buyers, sellers, and financial intermediaries, enhancing the trade ecosystem.
In commodity trading and finance consortia, tokenized LCs provide a standardized, secure solution, improving interoperability among sector participants.
As a result, tokenization of LCs is poised to transform trade finance but requires industry collaboration, regulatory backing, and technological progress for widespread implementation.
Downsides of Adopting DLT Technology
Even though there are many benefits to adopting and utilizing DLT technology for tokenizing letters of credit, there are many downsides as well, including:
A lack of DLT systems that are working on digitalizing the traditional finance space currently. There is also lack of global digital standards for trade to be used by these platforms that hinders the interoperability and communication between them. Fully on-boarding all parties in a trade process onto a digitalized platform will take a lot of time and effort during these early stages.The digital transformation of demand guarantees and documentary credits
The digital transformation of the banking operations of guarantees and documentary credits to shift from the…
www.tradefinanceglobal.com
How to bring more digital adoption to E-Letters of Credits
APIs.
Utilizing APIs that can be easily implemented into new or existing systems, which would bring easier access to platforms that want to utilize electronic LCs. Using interoperable DLTs that can easily transfer data and value amongst each other will be a solution to the lack of interoperability. An example of this would be SWIFT’s PoC that was conducted earlier this year, for the use of a universal API contract. The API brought a more secure and interoperable process with document issuers and SWIFT-
The digital transformation of demand guarantees and documentary credits
The digital transformation of the banking operations of guarantees and documentary credits to shift from the…
www.tradefinanceglobal.com
Pilot Testing
By conducting pilot tests for E-Letters of Credit it can show the potential of implementing them in real-world situations. Pilot tests are great because they can identify all the pros and cons, which can help the participants make adjustments before widespread adoption. An example would be an article written by GTR, a few years ago, that showcased a pilot test between multiple parties. The pilot highlighted the utility of an electronic letter of credit in the test with other key trade documents in electronic form. The electronic letter of credit was issued and completed in less than 2 hours, compared to a transaction that normally would take 1 to 2 days the traditional way. Another key benefit is having the ability to conduct multiple payments on one LC, compared to one payment traditionally.
User Experience (UX)
Creating a user-friendly platform is key to bringing a seamless transition from the traditional LC process to the digitalized version. The digital platforms should include an easy-to-use way of managing and tracking the LCs for all of the parties involved in the transaction.
Standards.
Creating standards around digital trade can be a solution to these issues as well. Implementing standards like GLEIF ’s LEI can create a unified verification system due to the required compliances with KYC/AML verification to conduct transactions with other parties. Greater adoption of UNCITRAL’s MLETR would make it easier for countries to implement the model laws of what a digital document is and how they can be transferred and verified. Aligning with MLETR can bring greater access to trade globally, ICC UK states, aligning with MLETR can bring up to £250 billion ($313 billion USD) in trade. Lastly having greater adoption of the eUCP which proposes eRules for the already existing UCP 600 guidelines that was proposed by the ICC, for letters credit will further the adoption of electronic LCs.
Home - GLEIF
Money laundering poses an inordinate threat; the Bank for International Settlements (BIS) estimates that between $2-$5…
www.gleif.org
In conclusion, the integration of blockchain and tokenization into the realm of Letters of Credit stands as a beacon of promise for revolutionizing trade finance worldwide. The positive impact of this technological leap is multifaceted and profound.
By leveraging blockchain’s immutable ledger and tokenization’s fractional ownership, we unlock a future where trade processes are streamlined, transparent, and secure. This convergence not only accelerates transactions but also mitigates risks, reduces fraud, and fosters a level playing field for all stakeholders involved.
Widespread adoption of this transformative approach holds the potential to reshape the very foundations of trade finance, driving global commerce into an era of efficiency, accessibility, and inclusivity. It’s not merely a theoretical concept but a practical pathway toward a brighter future for trade finance on a global scale.
As we navigate the ever-evolving landscape of international trade, let’s seize this opportunity to embrace innovation, collaborate across industries, and pave the way for a more connected, efficient, and prosperous trade ecosystem. The journey has begun, and together, we can propel trade finance into a new era of unprecedented growth and reliability. Embrace the change, and let’s shape the future of trade finance, hand in hand.
Appendix.
Letters of Credit The digital transformation of demand guarantees and documentary credits Swift successfully tests electronic Bills of Lading interoperability solution CUTTING THE COST AND COMPLEXITY OF TRADE CREATING A MODERN DIGITAL TRADE ECOSYSTEM — The economic case to reform UK law and align to the UNCITRAL Model Law on Electronic Transferrable Records (MLETR) What are the problems with Letters of Credit? UNITED KINGDOM | CREATING A MODERN DIGITAL TRADE ECOSYSTEM CUTTING THE COST AND COMPLEXITY OF TRADE — Reforming laws and harmonising legal frameworks Electronic Letters of Credit Presentation under a Letter of Credit issued on the blockchain The digital transformation of demand guarantees and documentary credits Swift successfully tests electronic Bills of Lading interoperability solution Banks pilot new electronic bill of lading capability on Voltron blockchain platform#TradeFinance #BlockchainInTrade #LettersOfCredit #Tokenization #TradeTech #FinanceInnovation #GlobalTrade #DigitalTransformation #FintechRevolution #SupplyChainFinance #BlockchainTechnology #FinancialInclusion #TradeEcosystem #SecureTransactions #FutureOfTrade
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FollowWritten by Andrea Frosinini
69 Followers · 55 FollowingSenior Enterprise Analyst and Trade Finance professional with a passion for innovation. Recently, joined the Hyperledger community with the aim at offering a co
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