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Trade Finance: Digitizing Payment Instruments on Blockchain (Part 4 of 5)


Here’s how distributed ledger technology can eliminate process inefficiencies and reduce bank operating costs and risks in the financing of trade receivables in open account trade.

Payment instruments such as bills of exchange and promissory notes are popular payment settlement mechanisms in international trade, especially within emerging market economies. These instruments are also safe and attractive investments for the bank or forfaiting house.

However, the workflow disconnects between the trade and financing sub-processes contributes to a lack of oversight into the trade interactions underlying the payment obligation. This, along with the paper-based nature of the receivables instruments and manual process flows, leads to sev­eral challenges in receivables financing, including fraud, compliance and default risks.

Blockchain/Distributed Ledger Technology in Action

Since payment instruments are essentially credit instruments created by the trade transaction, rather than being tokenized or dematerialized, they can be directly issued on a blockchain network as a native asset. Payment instruments can be digitally created as finan­cial contracts between the issuing and the redeeming parties.

Depending on the underlying blockchain or distributed ledger technology (DLT) protocol, a receiv­able asset can be issued by the owner as a special type of transaction and uniquely defined with an asset ID, ownership, and metadata to specify quantity, value, type and other attributes, along with business rules for change in ownership and redemption. These assets can be transferred by the owner, split or combined with other assets through new transactions, which are finalized through consensus and immutably recorded on the ledger. 

After the transfer is finalized, the new status is visible to all parties on the blockchain network. The previous owner no longer has control of the asset; it can be further transferred or redeemed only by the new owner of that instrument. Similar to its creation and exchange, the payment against receiv­ables can also be done quickly and efficiently on the blockchain network without the need for physical presentment or delivery (see figure below).

Figure 1

Blockchain Benefits

Payment instrument digitization on blockchain reduces business risks for banks in the following ways:

  • Prevents fraud stemming from duplicate invoicing and misinvoicing: By digitizing receivables on blockchain networks, organizations could link the issued assets to the underlying trade transaction in a verifiable and immutable manner, eliminating the risk of fraudu­lent transactions. Doing so also prevents misinvoicing as participants can verify and track the ownership and value of the asset at all times. For receivables assets issued directly on a blockchain, the duplicate financing problem (aka, double spend) is also automatically eliminated because the asset can only be transferred once by the current holder, and the novation is immutably stored on a blockchain through consensus.

    In the case of supplier financing, the ability to place all invoices and receivables seeking financing on a blockchain network makes it possible for financiers to query whether a receivable has been financed elsewhere before approving its financing. This can be done while preserving data confidentiality, by hashing these on blockchain and masking confidential attributes.

  • Improves financing for small- and medium-size enterprises (SME) through better trade visibility and collateral liquidity: The coming together of trade entities and their financiers on a common blockchain network provides the latter with increased insight into the receivables lifecycle and associated trade transaction infor­mation, as well as verifiable data on SMEs’ past payment history and credentials, enabling better and faster assessment and credit approvals. 

    End-to-end supply chain visibility on blockchain networks also provides financiers with a more accu­rate understanding of the risk and dependencies of small suppliers because they can see these in the context of the bigger payment value chain. This visibility also allows small suppliers to secure better terms of financing for working capital needs since risk assessment can be based on the corporate buyers, which have stronger payment credentials due to their large size and scope of operations.

    Blockchain enablement also facilitates efficiency in funding and loan servicing through the use of self-executing smart contracts for conditional disbursement of funds based on loan covenants and collateral status tracking.

    A financial asset natively issued on a blockchain network is more liquid due to the ease of authenti­cation and transfer. Its value as a payment obligation for an underlying contract is also verifiably linked to the overall trade transaction, making it more acceptable to third parties. This increased liquidity and acceptance facilitates secondary market trade for re-discounting receivables to other factors and makes it easier for financial institutions to offload these assets, further reducing SME financing risks.

  • Reduces process inefficiencies: A third benefit of asset digitization on blockchain is the elimination of delays, discrepancies and errors in the management of payment instruments, leading to substantial process efficiencies in their issuance, transfer and redemption. This also reduces costs and increases operational agility for banks by eliminating reconciliation effort and leading to faster disbursement and early receipt of funds for the supplier.

    Digitization also eliminates the possibility of loss through damage or theft as the asset value is securely and immutably stored on the blockchain network, and only the current owner is authorized to initiate asset ownership transfer.

Assessing Industry Impact 

During the last couple of years, several industry initiatives have emerged to explore blockchain/DLT applicability for trade payables and receivables financing, with a focus on SMEs. As these networks move from proof of concept and pilots toward production readiness, banks and other participants need to address broader issues around regulatory compliance and legal acceptabil­ity of these digital assets, as well as manage operational challenges in on-chain settlement of these assets through fiat-backed tokens or cash on ledger functionality. 

Other considerations include achieving interoperability between different platforms and networks; DLT integration with back-end banking systems for enabling the convergence of the physical, financial and information supply chains; and designing easy-to-onboard, commercially viable solutions with a zero-infrastructure foot­print option to encourage adoption by banks, trading parties and third-party service providers.

Part 1 of the series provides an overview of the three areas of trade finance that could most benefit from blockchain. Part 2 looks at payment method automation, using blockchain. Part 3 explores trade asset tokenization with blockchain.

For the full report, please see “Blockchain for Trade Finance: Payment Instrument Tokenization (Part 4).” For the other reports in the series, please see “How Blockchain Can Revitalize Trade Finance (Part 1),” “Blockchain for Trade Finance: Payment Method Automation (Part 2)” and “Blockchain for Trade Finance: Trade Asset Tokenization (Part 3).” You can also visit us at our Blockchain & Distributed Ledger Practice website. 

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Trade Finance: Digitizing Payment Instruments on Blockchain (Part 4 of 5)