Transforming Trade Finance Incrementally
12.68
class=21>In many discussions of the potential impact of blockchain on trade finance, the focus is on letters of credit both because they are such an anachronism and because letters of credit are presumed to be ‘the most common payment system in international trade transactions’.[1215] While the former point is clearly correct, the latter point is clearly incorrect. Industry experts have long recognised that ‘documentary letters of credit' used to finance trade transactions were dying out.[1216] In 2008, one industry expert estimated that, while as much as 80% of cross-border trade transactions were once covered by letters of credit and 20% covered by other mechanisms, the proportions had reversed with only 20% of trade transactions being financed with a letter of credit and 80% with other mechanisms.[1217] More recent estimates of the proportion of cross-border trade financed by letters of credit are even lower: 12.5% in 2016,[1218] and 10% in 2019.[1219] In other words, one of the primary use cases for blockchain in trade finance—replacing letters of credit—may be illusory. The role of banks in providing trade finance was already in steep decline as a result of changing business models incross-border trade and improvements in legacy technologies long before blockchain was invented.
12.69 Alternatives to letters of credit include sales on open account (exporter extends credit to importer), prepayment (importer extends credit to exporter), trade credit insurance, factoring (lending secured by accounts receivable based on the borrower’s creditworthiness), and reverse factoring (lending secured by accounts receivable based on the borrower’s customer’s creditworthiness).
In advanced market economies, vendors commonly extend credit to their customers for thirty, sixty, or ninety days depending on industry custom and information gathered about the borrower’s creditworthiness. Granting trade credit for cross-border transactions is riskier because reliable, objective information about a prospective borrower’s creditworthiness may not be available and the legal remedies available to the exporter in the importer’s national legal system in the event of default may be unsatisfactory. At the other extreme from open account, in which the exporter bears the full risk of non-payment by the importer, is prepayment, in which the importer bears the full risk of non-performance by the exporter. Only an exporter with significant market power would demand prepayment because such unfavourable trade terms will drive away many prospective customers.12.70 A letter of credit requires one or more banks to become deeply involved in the administration of the transaction, but the independence and strict compliance principles of letter of credit law restrict the scope of a bank’s participation to the analysis of supporting documents. When parties engaged in trade had few choices other than prepayment/open account or letter of credit as payment mechanisms, these doctrines contributed to the profitability of the banks’ trade finance operations.
12.71 'The use of paper- based supporting documents has been declining in recent years as global supply chains have continued to expand and investment in trade-facilitation processes has increased. Supporting documents, such as certificates of origin, inspection certificates, and insurance binders, are often provided in electronic form today. Bills of lading as documents of title have long posed unique digitisation challenges, but those may also be less daunting than they once were.[1220] For example, a US retailer might decide that the volume of its purchases in China justifies maintaining its own logistics facilities at ports in both China and the US and entering into ‘volume contracts’ with trans-Pacific carriers.
When the retailer’s agents in China receive container-loads of goods at a Chinese port, the retailer would thus become the outright legal owner of the goods before they are ever loaded on ships bound for the US. Within such a framework, the retailer could easily dispense with paper bills of lading, relying instead on data exchanged between the Chinese subsidiary and the US parent company to track the movement of the goods through its global supply chain.12.72 If both banks and traders expect the proportion of trade transactions financed by letters of credit to continue declining, it is hard to see how any blockchain-enabled version of the letter of credit could ever gain enough momentum to achieve widespread adoption. The difficulty of convincing uncertain users to make the leap to a new collective solution increases if most users expect a market to shrink in the future, instead of growing.
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