Defining the Standby Letter of Credit and Its Purpose
What is a standby letter of credit? Also referred to as an SLC or LC (letter of credit), these are obligations issued by a bank in written form, the purpose of which is to promise payoff of a certain sum of money to a beneficiary. These obligations are issued on behalf of the customer in case he or she does not pay for a service or product provided by the beneficiary.
In the following arrangement, a bank provides payment backup in the case of unpredicted situations in which the customer fails to pay for a service they have received. The bank then appears as an independent third party that does not hold interest. The issuance of standby letters of credit is considered a private transaction, the process of which isn’t related to any public trading security issuance.
The use of standby letters of credit is advantageous for beneficiaries, as they ensure:
- getting paid under any circumstances
- Completion of a product or service on time
- that all agreement terms are complied with
As a result, even if a customer fails to pay for a provided service, the bank does it for him or her, and is responsible for reimbursing the recipient’s funds.
There also exist a number of standby letters of credit, and their type depends upon a range of factors.
The general idea of standby letters of credit is advantageous and useful. However, it should be stated that the process of receiving such obligations is very complex, as it involves numerous parties and takes approximately 60 days to be confirmed.
First, let’s take a look at a simple example in order to understand the exact situations in which standby letters of credit can be applied.
- Let’s say a customer and a provider want to settle a deal. The customer can request certain products from the provider; or perhaps the provider promises to conduct a certain service (like building a pool in the customer’s yard).
- The provider questions the fact that the customer will pay on time, and in order to eliminate this risk, asks him or her to provide a standby letter of credit.
- The customer goes to the bank and requests the SLC. If the documentation is fine, he or she receives the obligation.
- The provider reviews the SLC in order to ensure that it is acceptable, and makes a decision whether or not to proceed with the arrangement.
- In case the customer fails to comply with the set conditions and obligations, the provider receives his or her funds from the bank that issued the standby letter of credit.
In order for a customer to have his or her SCL approved, there are a number of steps to go through. The process involves numerous parties. Have a look at this list of the individuals involved in standby letter of credit issuance:
In industry, the process of financial link automation between trade finance and cash flow is very complex, as we have mentioned above. The graphic below illustrates the traditional flow of this process:
Therefore, the complexity of standby letter of credit issuance results in:
- operational inefficiencies (manual and paperwork, time consumption, lack of standardization)
- working capital (balance-sheet implications)
- lack of visibility (not knowing holistic exposures)
Blockchain as a Solution to Trade Finance Complexity
Blockchain is a new distributed ledger technology that has been applied in all types of industries in order to correct workflow inefficiencies. It is one of the best solutions for cutting down on paperwork, eliminating third-party involvement, establishing safe and transparent data storage, and providing security in transaction processing via smart-contract use.
The financial industry benefits from blockchain applications in numerous ways. As a result, 77% of companies (respondents) are ready to implement it, according to FinTech research.
“With blockchain implementation, the trade finance industry can easily establish transparent and secure communication via the decentralized ledger, and deals can be executed much faster than traditionally. Automated execution is enabled via smart-contract use, and ensures that all participants adhere to a set of predefined requirements. Moreover, all relevant information concerning trade procedures, participant data, and transaction processing can be all viewed and easily accessed, providing a higher level of trust and transparency,” states Stanislav Sheliakin, Applicature business analyst.
Blockchain Applications for Letter-of-Credit Issuance
As we discussed earlier, the process of SCL issuance is complex, and faces such issues as time consumption, excessive manual work, and lack of transparency. To solve these issues, banks have become more interested in blockchain technology implementation, as it is capable of solving all of them. An innovative factor in the financial industry is the fact that an immutable record entered into the blockchain once can serve as a means of verification and prevent any data forgery.
When applied to the process of SCL issuance, blockchain contributes by:
- streamlining documentation processing via automation or use of AI
- enhancing security by reducing human-error factors and providing privacy with encryption
- predicting working capital and providing accessible information through via user interface or mobile application
Blockchain’s advantageous properties also provide the following solutions:
- Documentary fraud elimination (due to the features of transparency and consensus-reaching)
- Product authenticity (due to traceability and transparency)
- Secure value delivery and transaction processing (via immutable record storage and digital signature uniqueness)
- Privacy between participants (due to cryptography and the use of private or consortium ledgers)
- Flexibility and robustness (due to blockchain’s decentralized nature)
- Cutting on the downtime and delays (due to automated deal execution via smart contracts)
- The ability to move various assets while tracking and purchasing them at the same time (with IoT application).
Considering its list of pros, many companies have turned to blockchain integration. Here are several examples to consider:
Microsoft. Microsoft treasury and Microsoft blockchain-as-a-service have worked with the Bank of America to automate the standby letter of credit procedure. With blockchain integration, they used proof of concept (POC) consensus and managed to enhance their:
- speed and efficiency of execution
- real-time data and audit tracking
- transparency and trust between users
As a result, the process of SLC issuance was simplified, and could be conducted in 40 minutes instead of months:
BBVA. This company used blockchain technology from Wave, and managed to cut international trade processing time (submitting, verification, and authorization) from a week to just two to three hours.
“The operation was registered and securely validated at the same time for all parties, thanks to the distributed ledgers and the immutability of blockchain,” comments Daniel Berenguer, Head of Digital Trade at BBVA.
HSBC. This is the seventh-largest bank in the world. It recently issued an LC for the American food company Cargill via blockchain. As a result, with the use of the Corda blockchain platform, they managed to settle the deal in just 24 hours.
As a matter of fact, more and more financial trade companies are turning to blockchain, as it is especially convenient in terms of logistics and trade operations. The issuance of standby letters of credit within blockchain technology stands as a bright example of the technology’s functionality and utility.