Executive Summary

Digitalization is influencing business models and strategies for corporates and banks in Trade Finance. This is primarily due to its power to simplify and to reduce costs, while also allowing banks to better serve small to small medium enterprises (SMEs) and stimulate trade flows. The benefits of digitalization are now widely accepted because of its capacity for reduced risks, increased speed, improved working capital management, efficiency, transparency, and operational improvements, to name but a few.
In times of slowing trade growth, the wider macro-economic benefits of digitalization also deserve attention. In fact, the World Trade Organization (WTO) estimates that technological progress will have the largest impact on GDP levels by 2035, accounting for 9% higher or lower GDP levels in developed countries. In emerging markets, the variation is even greater – up to 20% higher or lower GDP in Brazil and 55% in China.
When the cost of processing a Letter of Credit (LC) decreases, so too does the entire cost of trade finance – which enables financial inclusion. The ease of the process also facilitates customs clearance procedures, allowing goods to move through supply chains more easily and reach consumers faster.
Blockchain applications have the potential to streamline various trade finance processes. A blockchain is a data structure that enables the creation of a digital ledger storing all transactions. It is distributed across a digital network with cryptographic mechanisms. As a result, it enables each participant in the network to securely update that ledger without the need for a central authority. A blockchain ledger gets updated in real-time by each participant on the network to reflect the most recent transaction. Therefore, it eliminates the need for multiple copies of the information documents stored on numerous databases across various entities.

The Current Challenges & Risks with Trade Finance.

Trade finance by financial institutions like banks is a vital function in international business as it provides delivery and payment guarantees to buyers and sellers involved in a trade while closing the trade cycle funding gap for these parties.
The growth and sustenance of the international trade market rely on financing mechanisms’ easy availability and robustness. However, trade participants can be vulnerable to business risks and uncertainties stemming from several factors. Those factors include process inefficiencies, variations in trade regulations and requirements across geographies, and the operational and logistical complexities arising due to the involvement of numerous entities. In a recent survey by the International Chamber of Commerce, reports showed an increasing trend in litigation and fraud related to trade financing over the last few years.

Other pain points include:
 – Payment and delivery delays due to process overheads and intermediaries
 – A lack of insight and traceability into the movement of goods.
 – Manual contract creation for counterparty due diligence and compliance processes
 – Manual AML review conduct using the financials
 – Multiple platforms are used by each party, and thus causing miscommunication and fraud.
 – Duplicative bills of lading due to the inability of banks to verify their authenticity
 – Multiple versions of the truth and version control challenges

For banks as well as buyers and sellers involved in the process, these obstacles can increase both risk and costs, leading to unfavorable financing terms, especially for small businesses.

    The Potential of Blockchain in Trade Finance

    There have been many attempts to create digital money in the past, but they have always failed. The prevailing issue is trust. If someone creates a new currency called the X dollar, how can we trust that they won’t give themselves a million X dollars, or steal your X dollars for themselves?

    Bitcoin was designed to solve this problem by using a specific type of database called a blockchain. Most normal databases, such as an SQL database, have someone in charge who can change the entries (e.g. giving themselves a million X dollars). Blockchain is different because nobody is in charge; it’s run by the people who use it. What’s more, bitcoins can’t be faked, hacked or double spent – so people that own this money can trust that it has some value.

    Blockchain is a system of recording information in a way that makes it difficult or impossible to change, hack, or cheat the system. A blockchain is essentially a digital ledger of transactions that is duplicated and distributed across the entire network of computer systems on the blockchain. Each block in the chain contains a number of transactions, and every time a new transaction occurs on the blockchain, a record of that transaction is added to every participant’s ledger. The decentralized database managed by multiple participants is known as Distributed Ledger Technology (DLT). Blockchain is a type of DLT in which transactions are recorded with an immutable cryptographic signature called a hash.

    Blockchain applications have the potential to streamline various trade finance processes. A blockchain is a data structure that enables the creation of a digital ledger storing all transactions. It is distributed across a digital network with cryptographic mechanisms. As a result, it enables each participant in the network to securely update that ledger without the need for a central authority. A blockchain ledger gets updated in real-time by each participant on the network to reflect the most recent transaction. Therefore, it eliminates the need for multiple copies of the information documents stored on numerous databases across various entities.

    This means if one block in one chain was changed, it would be immediately apparent it had been tampered with. If hackers wanted to corrupt a blockchain system, they would have to change every block in the chain, across all of the distributed versions of the chain. Blockchains such as Bitcoin and Ethereum are constantly and continually growing as blocks are being added to the chain, which significantly adds to the security of the ledger.

    Blockchain’s benefits can be looked at across three key areas in trade and international trade finance now and in the future.

    1. Providing payment certainty to sellers by automating payment methods:

    While payment methods like letters of credit (LC) provide an effective way to mitigate business risks through bank facilitation of the trade flow and settlement process, their value can be seriously limited by high costs, contractual delays and process complexities. Because LC compliance is evaluated based on trade documents and not the actual delivery or quality of goods, ambiguities in the semantics of the legal clauses in the LC contract necessitate the bank to apply discretionary determination when interpreting them. As a result, errors in terminology and interpretation of requirements commonly lead to disputes between parties, with goods sitting unclaimed at the delivery location.

    Payments can also be delayed by data mismatches between the LC contract and the underlying trade documents, which either require a waiver or acceptance from the buyer. Other delays can stem from corrections in the trade documents or amendments in the LC contract itself within a short time window before the LC expiration date.

    To mitigate the risk of delayed or denied payments, the LC can be modeled as self-executing contracts on blockchain. This would automate compliance verification with contract terms and ensure faster payment to sellers by preventing disputes from arising due to ambiguities in the payment contracts. Automating the payment method on blockchain also expedites payments through early discovery of discrepancies and increases the efficiency of the amendment process.

     2. Providing delivery assurance to buyers through trade asset tokenization:

    Visibility into the status of in-transit shipment is essential for buyers to obtain timely indications of potential delays and damages that can impact fulfillment of downstream obligations. However, buyers often lack this insight into en-route delays or shipment damage due to bad weather, port congestion, customs hold-ups and other reasons until the actual delivery of the shipment. This limits the ability to foresee and mitigate business risk. Trade documents also move separately from the flow of goods, leading to situations when goods cannot be claimed by buyers until the title or other physical documents have been received. Documents can also be easily forged or manipulated due to vulnerabilities in the transport chain resulting from fragmented interactions between stakeholders, variations in country-specific regulations and trade procedures, and an overall lack of security and common standards. This increases the risk of document fraud for trading parties.

    On blockchain, the trade asset can be digitized through crypto-tokens to denote custody or ownership of the bearer and link its transfer between trade transaction participants on blockchain with the movement of the physical asset, establishing a clear chain of provenance. The trade-related documents can also be directly issued and verified on the blockchain by relevant parties. Asset tokenization on blockchain provides delivery assurance and better risk management for buyers by enabling real-time shipment status tracking and visibility into transport conditions. Managing the flow and transfer of trade documents, such as bill of lading, on blockchain reduces hold-ups in the release of cargo to the buyer due to delayed receipt of trade documents, and it also prevents losses from document manipulation and errors.

    3. Mitigating risks and increasing financing revenues for banks through payment instrument digitization:

    Trade receivables and other payment instruments such as promissory notes, checks, drafts or bills of exchange act as negotiable instruments that can be transferred to third parties like banks and other financial institutions. This makes it possible for suppliers to get funding to meet their working capital needs by sale or transfer of these payment instruments through discounting, factoring or forfeiting.

    However, banks face challenges in detecting deviations and ensuring compliance because of process inefficiencies, such as limited availability of trade information, reliance on documentary proofs of trade, and the high cost of manual screening required, making them vulnerable to business risk. The resulting risks include substantial loss from financing fraud, such as duplicate financing and submission of fake receivables, reputational damage, costly lawsuits and ever-increasing penalties in the form of multi-million-dollar fines.

    Another key pain point in financing is the unavailability of sufficient and timely trade credit for SMEs, which generally receive deferred payment terms from corporate buyers but need liquidity in the interim to meet their working capital needs. The overhead involved in issuing, storing, transferring and redeeming receivable instruments in paper form also makes for an operationally inefficient, costly and time-consuming process.

    Since payment instruments are essentially credit instruments created by trade transactions, they can be directly issued on a blockchain network as native assets. Payment instruments such as bills of exchange or promissory notes can be digitally created as financial contracts between the issuing and redeeming parties. Direct issuance of payment instruments on blockchain prevents fraudulent invoicing practices, improves SME financing options through increased liquidity of receivables, and enables process efficiencies in managing receivables.

    Conclusion: Advantages of blockchain in trade finance and the future of international trade can be summarized below.

    1. Real-time review: Financial documents linked and accessible through Blockchain are reviewed and approved in real time, reducing the time it takes to initiate shipment.
    2. Transparent factoring: Invoices accessed on blockchain provide a real-time and transparent view into subsequent short-term financing.
    3. Disintermediation: Banks facilitating trade finance through blockchain do not require a trusted intermediary to assume risk, eliminating the need for correspondent banks.
    4. Reduced counterparty risk: Bills of lading are tracked through Blockchain, eliminating the potential for double spending.
    5. Decentralized contract execution: As contract terms are met, status is updated on Blockchain in real time, reducing the time and headcount required to monitor the delivery of goods.
    6. Proof of ownership: The title available within Blockchain provides transparency into the location and ownership  of the goods.
    7. Automated settlement and reduced transaction fees: Contract terms executed via Smart Contract eliminate the need for correspondent banks and additional transaction fees.
    8. Regulatory transparency: Regulators are provided with a real-time view of essential documents to assist in enforcement and AML activities.

      References:

      1. “2016/2017: Rethinking Trade and Finance,” International Chamber of Commerce, 2016/2017, http://store.iccwbo.org/content/ uploaded/pdf/ICC_Global_Trade_and_Finance_Survey_2016.pdf
      2. https://blockchain.oodles.io/blog/importance-blockchain-trade-finance-transformations/
      3. How Blockchain Can Revitalize Trade Finance -Cognizant
      4. How Blockchain Can Reshape Trade Finance- Deloitte
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