I was invited recently to take part in Blockchain Finance conference in Singapore as a panelist in a panel discussion about the use of blockchain for trade finance applications. I find this subject very interesting for many reasons that I will try to elaborate in this post. First I will just explain the main purpose and challenges of trade finance, and then what the benefit of blockchain in this particular field can be.
I wish to express the gratitude to the Blockchainer, Shanghai-based blockchain startup incubator with presence in various countries, for their invitation to this great event. The conference attracted 300 participants, and it was pleasure to learn the state of the blockchain finance sector in South-East Asia and China. There were many talks about blockchain payments, blockchain insurance, distributed funding, custodian services, cryptoexchanges, innovations in investing in blockchain projects, regulatory situation etc Beta Feng was great organizer of this event. Now, back to my topic.
What is trade finance ?
Trade finance means simply financing trading activities. Lets say a manufacturer or agriculture producer is making, or has already made a product and would like to sell it. Lets say that there is also a buyer that would like to buy, or maybe import to its country this product. The seller can invest money itself in the whole process, sign the sales contract with the buyer, load the goods on a truck or a ship, and wait for the buyer to confirm the acceptance and pay for the goods upon reception. The buyer can also decide to buy, sign the sales contract, wait for the goods to arrive, and pay the products from its own funds on at the time of reception of the goods. But often, they would decide to approach financial intermediaries (banks) to cover with a loan for this period while the goods are being produced, shipped and verified. This loan is one of the instruments of trade financing. The benefit of this loan is to provide the liquidity to the seller to buy the machines so that she can focus on making the product, improving the manufacturing, to perform the R&D etc. Using this financial instrument, the seller doesn’t need to wait for the goods to be shipped and received by the buyer. On another hand, the buyer doesn’t need to pay immediately for the goods. He can use the money for some more time (30 – 90 days) for the marketing promotion, to cover for logistics and warehousing costs, retail distribution. Trade finance instruments hence have a very important role in providing the bridge between the moment when the seller starts producing the goods and the moment when these goods are being paid for by final consumers. These instruments represent also a guarantee of payment, as seller and buyer very often don’t have history of mutual interactions to be able to trust each other So, the trade finance instruments allow all trade participants to focus on those activities they can perform the best: seller on production, buyer on distribution. In this way during the last 20 years, trade finance has stimulated, accelerated and expanded the globalization process to such extend that we can say that without these financial instruments there would have been no globalization today.
What are these financial instruments? Some of them are simple, like open account trading, advance payment, documentary credits and similar. Some are complex and include several participants and multiple control points. But in all of them, the intermediaries who provide this bridge funding will carefully manage risks. There are many kinds of risks, like manufacturing, product, transport, payment, and currency risks Most often, the financing providers will require the backing of the loan with the collateral, which in a simplest case is the goods itself being sold.
So, this is (very simplified) theory behind trade finance. It applies to commodity trading, or to trading of finished goods (machinery, consumer products, etc).
It is important to mention that global trade has always been very much influenced by technological progress and several innovations have particularly contributed to accelerate trade. Money is one of them. Money was invented to facilitate the trade, as before money the trade was limited to exchanging the goods between two participants. Money enabled people to understand the value of their goods and easily negotiate the price. Next, the standard-sized shipping container was the second most important invention, because it became possible to densely pack different products into these containers, stack large number of them on the ships, unload them quickly onto the trucks, and transport the goods efficiently to the final destination. Invention of large ships and barges made it also possible to transport huge quantities of goods per sea, the cheapest way of freight transport.
So, trading companies have always looked into the opportunities offered by technology to optimize and accelerate the trade process, in both logistics and financing the operations. And since the computers were invented, the trading companies were working on using them to gain efficiency. The big dream has been to automate the interactions between participants, but as of now, the trade transactions among sellers, buyers are their financing providers are still manually entered into their internal accounting systems, in many cases based on paper documents sent by DHL from one party to another. Automation of their internal processes has been achieved to a high degree, but the processes involving multiple parties are still manual, taking long time and suffering from many inefficiencies. One of the reasons of the lack of overall automation is (again) the mistrust between participants. There were many initiatives to introduce various digital platforms, but they until now have not been successful.
Now we have Blockchain
Two blockchain features are the most important when considering trade finance. First is distributed ledger. This means that if, let’s say, we create a network of 100 participants, each of them will have a full copy of all transactions on their computer. In case of private blockchains, one participant will see only those transactions described in the network’s rulebook where they are authorized to have access to. In case of public blockchains, all transactions will actually be accessible (private information will be hidden behind public keys, of course). The second feature is immutability. Modifying the previously committed transactions in the blockchain is technically very difficult and in some cases would be possible only through a hard fork where all participants agree to redo all transactions following the one that they want to change. It is not the same like in a centralized database, where a hacker or someone authorized by the management can change all data if they decide to do so. In blockchains, all participants must agree to this change and make conscious efforts to implement it.
These two important blockchain features in fact provide an environment in which the participants feel more confident in the reliability of the information they exchange and transactions they perform.
Of course, blockchain is not an all-cure medicine. If the data which enters the system is fake, and other participants are not aware of its incorrectness, blockchain will keep its record. So, validation of the trade documents and trade-related information will remain an important task to be done “off-chain”.
We should add here also automation through smart contracts. These are programmable blockchain scripts, which can perform certain tasks if they are invoked by the participants, or which can trigger in case of a particular transaction. Example would be: bill of lading is accepted by the validation organization, which will automatically trigger the generation of the payment request. The level of automation is of course configurable. For repetitive and well-understood operations, it can be fully automated, but for those requiring care and due diligence, smart contracts could be organized in such a way to involve human control points. Currently in this new world of distributed blockchain applications, an application could consist of hundreds of smart contracts that are enchained in order to implement very complex scenarios. The beauty of these applications is that they can invoke internal procedures and applications of various participants, can lookup external data resources like latest currency rates, or can use machine learning algorithms to perform classifications or identify the best course of action. And the end result, a new transaction or a record is included in a new block and accepted by all nodes in the network. So, we can have all three : automation, decentralization and immutability.
So far so good. The question really is if all this is sufficient in order to persuade typical sellers, buyers, and financial intermediaries of the trade finance process to trust the technology and trust each other, and really go forward in integrating more seamlessly interactions among themselves, which until now has not been the case.
It is worth mentioning that there are other solutions based on blockchain, which can complement nicely with the new trade finance platforms and applications. For example, blockchain-based payment systems, which aim to reduce the cost and automate the cross-border payments among the banks or among the end consumers. IBM’s Blockchain World Wire is one example of it. Another example is Chinese startup everiToken. There is also a set of solutions for the global supply chain, where participants can follow the flow of the goods. IBM’s TradeLens is an example of this as well. Many of these auxiliary solutions can add value to the trading process.
Hope this explanation on how blockchain supports the trade finance is rather easy to understand. Now the questions I got during the blockchain trade finance panel discussion were quite interesting, so I will comment also on them.
One was : “Are the consortium-based platforms the right way to promote the use of blockchain for trade finance, and are these consortia going to become a new norm?”
Indeed, many trading companies have recently started forming networks based on blockchain platforms. These networks are organized as consortia. Examples are We.Trade, eTradeConnect, Voltron, Marco Polo, Komgo and many others. It is enough to google these names to find quite a lot of latest information about their approaches and participants. Most of them use one of three underlying blockchain technologies: IBM-supported Hyperledger Fabric, R3 Corda or JP Morgan’s Quorum (which is based on Ethereum). I think this way of self-organizing, as of 2018 and 2019, is a very interesting way of experimenting with the technologies, learning how to benefit from them and how to automate the existing business rulebooks. Some companies are actually members of several networks, which allows them to compare the different concepts.
These networks will necessarily evolve, eventually more participants will come, more complex instruments will get implemented. I expect that the solutions will scale and the adoption will grow. As of April 2019, only a small number of transactions is being done through blockchain, and many of these are done in a parallel-run basis, alongside the traditional systems. I expect that it will take few years before the adoption grows to such a level that participants decide to move completely to the new blockchain-based solutions. In this sense, having three different platforms to play with is actually an asset. It also allows the technology providers to learn from each other and improve the existing solutions.
The second question was “what will be the role of the public chains in trade finance?” Very interesting question. Currently all trade finance is being done in B2B space, in particular among large companies. The problem is that smaller manufacturers and sellers from underdeveloped countries, even if they have capacity to produce and export interesting and good quality products, their funding applications are very often rejected by the banks who are not able to evaluate the risks, especially in the context of the still present consequences of the financial crisis from 2008. The current financing gap, as reported by WTO in their latest report, amounts to $1.5T. This is huge amount, which could in fact unlock the economic growth of many developing countries. The question for me is : can blockchain help to cover at least a part of this gap? I bet this is the role of public chains, with all financial instrumentation that they bring with them : tokens/ cryptocurrencies, cryptoexchanges, ICOs etc. Democratization of this process is a big promise, so I believe that there will be definitely a number of new solutions for this domain not covered by the existing intermediaries. I cannot comment on the details of the implementation of this kind of solutions, but there are many options and potential ideas.
At present, private and public blockchain platforms stimulate each other’s development much more than they compete, as they cover completely different market segments. As of now, trade finance participants (who are mostly large and regulated organizations) still view blockchain as an experimental platform which needs to prove itself, so they use it for a small proportion of their transactions. But as these participants gain experience and confidence, this will also stimulate the development of new solutions for smaller value loans, either by major platforms or by somebody completely new in this field. Optimistic scenario for me would be that in 3-5 years we see around 50% of the current world trade finance being performed on-chain with newly proposed B2B platforms, and that first solutions for the smaller value trade loans are being implemented on some kind of public chain.
The topic of blockchain for trade finance is very important, as trade finance is a pillar of the global world as we know it. Trade finance needs to be more efficient and more inclusive. As the shipping containers have indirectly enabled globalization, the world now needs a new set of solutions to further accelerate and expand the trading process.
There are many promising innovations : freight drones, hyperloop, unmanned ships, robotic container loading and unloading etc.But the most important innovations in trading and trade finance are expected to be in the domain of trust. And if blockchain can help achieve the needed trust among market participants from different parts of the world, in the situation of increasing complexities and difficult-to-understand risks, this will unlock the tremendous opportunities and a new phase of the human development. The impact is enormous. But it still needs to be seen if and how blockchain will actually make it possible to get there.
Sasha Lazarevic, April 2019