Letter of credit system needs a digital update

Published 1:30 am Saturday, December 22, 2018

In the late Middle Ages, international travelers didn’t have credit cards in their wallets. Merchants in pursuit of international trade carried some gold, of course, but increasingly they also carried a document called a letter of credit.

A letter of credit was really a paper form of a credit card in that it allowed two people who didn’t know each other to trade goods and services through a third party that they both knew to be creditworthy. It was a tedious, document-heavy process, but it worked to support an active international trade.

If you have ever been involved with international letters of credit, you immediately recognize that Einstein was absolutely correct — time travel is possible. And you feel that you have been transported back 500 years.

Letters of credit still function to allow two companies that don’t know one another to exchange goods and services with the assurance that the seller will be paid in full. Unfortunately, despite some improvements wrought by computerization, it also still functions like the tedious, document-saturated process that any medieval merchant would recognize.

It was pretty obvious that the letter of credit system needed updating. The Internet had broadened commercial buyers’ options for suppliers and it became much easier to compare prices. In a global market, dealing with an unknown seller wasn’t unusual at all.

There was a second factor also. Fiction had become fact. In the late 1980s and early ’90s, in a TV program called “The Days and Nights of Molly Dodd,” there was a running gag in which the title character, played by Blair Brown, would order Chinese food over the telephone and a few minutes later there would be a knock at the door by the delivery guy, who explained the fast service by crediting “astral projection.”

The real-life version isn’t as fast as astral projection but sometimes it’s pretty close. Today, retail firms, most notably the market leader, Amazon.com, can deliver orders to your doorstep within two hours. In Molly Dodd’s time it wasn’t all that unusual to have to wait that long for your food to show up.

The letter of credit process, though, was relatively untouched by either modern technology or changing customer demands. As time passed, it fell farther and farther behind the reality of the market. Clearly, it was a system in need of a serious updating.

The timing was right, then, for two innovations: Blockchain, which digitized the paperwork to some extent; and Bitcoin, which introduced a digital virtual payment system.

Both innovations have a disappointing side. Bitcoin, as it turns out, appeared unable to shake its shady reputation, for its initial benefit seemed to be people who wanted stuff from foreign countries but really, really didn’t want their names attached to the transaction. While the virtual currency did enjoy a life in a speculative bubble — not unlike the seventeenth century Dutch “Tulip Mania” — its value has plummeted, and its continued existence appears questionable.

Blockchain, which started out on the unglamorous side of international trade transactions, was initially unready to take on the demands of buyers and sellers — demands which were being met by mounds of paper documents. And it still has some aspects that limit its capabilities and reduce its appeal to businesses.

One of these limits is the inefficiency of the transaction model on which it is based. That level of inefficiency is the underlying reason why the initial software for Blockchain could only process one transaction per second — hopelessly slow for international trade volumes. That problem was gradually addressed, and the newest version of Blockchain from IBM, pushes the rate to 1,000 per second.

A second limit is that commercial banks have not really bought into the system. They are the source of the credit that makes the whole transaction between strangers possible and they are very much needed. This limitation may dissolve as Bitcoin’s role fades, for it was the virtual coin’s ability to conceal identities that raised the antennas of federal authorities.

The third limitation will be the toughest to resolve. In its current form, Blockchain’s basic model is fully understood only by the information technology officers, not top management. This is a significant marketing limitation and it can be cured by a system model that is more straightforward. and less likely to give the CEO a headache when explaining it. Blockchain may get some assistance in this, though, as commercial banks become more active participants in the process.

One thing is not in doubt. Whether it is Blockchain or some successor product, the existing, paper-document-heavy letter of credit system will be replaced with 21st century technology. And few will mourn its passing.

James McCusker is a Bothell economist, educator and consultant.