Trade finance is often described as the fuel for global commerce, as it provides delivery and payment assurance to buyers and sellers, and it helps close the trade cycle funding gap. However, trade participants can be vulnerable to business risks and uncertainties. In addition to fraud, pain points in trade finance include payment and delivery delays due to process overheads, a lack of insight into the movement of goods and the effort required for counterparty due diligence and contractual compliance processes. These risks and inefficiencies have limited the size of the trade finance market, which currently stands at $4 trillion to $5 trillion, adversely affecting growth in global commerce.
For this reason, the trade finance industry has emerged as a key focus area for realizing the benefits of blockchain technology. Blockchain has the potential to:
Reduce disputes and fraud to provide delivery and payment certainty.
Enable transparency of trade asset movement.
Facilitate the flow of trade receivables.
The result: increased collaboration, automation and oversight in trade transactions.
Key Elements of Blockchain
Three key features of blockchain are instrumental in treating the major pain points of trade finance:
The cryptographic security underlying blockchain technology enables information immutability and credibility. This capability renders trade transaction records stored on blockchain tamper-proof, reliable and verifiable by all parties at any time. Data confidentiality and privacy are ensured through permissioned access rights for trade participants.
The distributed ledger architecture provides transaction transparency and traceability. This increases visibility into asset status for merchandise tracking, enables automated execution of contractual obligations through smart contracts, and ensures networks are resilient to downtime and manipulation risks.
The network consensus mechanism provides a single source of truth for enabling native issuance of financial assets (trade receivables and other payment obligations). It also eliminates the associated problems of double spend, fraud and the need for continuous reconciliation between trading and financing parties in the transfer of these digital assets.
Together, these features provide the foundation for building robust and synergistic trade finance ecosystems and platforms that substantially increase the efficiency of trade processes, eliminate fraud, improve asset liquidity and provide better visibility into the trade supply chain.
Addressing Three Pain Points of Trade Finance
Blockchain’s benefits extend across three areas of trade finance:
Providing payment certainty to sellers by automating payment methods.
While payment methods like letters of credit (LC) help to mitigate business risks, their value can be seriously limited by high costs, contractual delays and process complexities. Namely, ambiguities in the semantics of the legal clauses in the LC contract can require banks to apply discretionary determination when interpreting them, which commonly leads to disputes between parties, with goods sitting unclaimed at the delivery location.
To mitigate the risk of delayed or denied payments, the LC can be modeled as a self-executing contract 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. Payments would also be expedited through early discovery of discrepancies and increased efficiency of the amendment process.
Providing delivery assurance to buyers through trade asset tokenization.
Buyers often lack insight into en-route delays or shipment damage, which limits their ability to foresee and mitigate business risk. Because trade documents move separately from the flow of goods, buyers are unable to claim goods until the title or other physical documents have been received. They are also susceptible to fraud because documents can 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.
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 also enables 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 delayed receipt of trade documents, and prevents losses from document manipulation and errors.
Mitigating risks and increasing financing revenues for banks through payment instrument digitization.
Trade receivables and other payment instruments act as negotiable instruments that can be transferred to third parties like banks. This makes it possible for suppliers to get funding to meet their working capital needs. However, it’s not always easy for banks to detect deviations and ensure compliance because of limited availability of trade information, reliance on documentary proofs of trade, and the high cost of manual screening.
Another key pain point in financing is the unavailability of sufficient and timely trade credit for SMEs. Since payment instruments are essentially credit instruments created by the trade transaction, 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.
Though the potential for disruption is immense, multiple hurdles need to be overcome before the promise of blockchain for trade finance can be realized. As a result, blockchain adoption will need more concerted evangelization efforts to build industry momentum and accelerate implementation.
For the full report, please see “How Blockchain Can Revitalize Trade Finance (Part 1)” or “Blockchain for Trade Finance: Payment Method Automation (Part 2).” You can also visit us at our Blockchain & Distributed Ledger Practice website.