The impact of Blockchain on trade finance
A 21st century solution for a centuries-old business
- Blockchain is a technology which allows for an automatic and safe check and execution of transactions
- Blockchain offers the opportunity to finance trade more cheaply and with less risk
- Banks will remain an important player in the field of trade finance
Trade finance is an activity that has been around for a while, but has not seen much innovation in that time. In fact, it is still a largely paper-based business. This makes it more error-prone, time-consuming and fraud-sensitive than it could be.
Blockchain has the potential to change this. It provides an efficient and secure way of quickly settling trade transactions. This brings down costs, lowers operational complexity, reduces risk and lowers working capital needs.
In this publication we give a brief introduction of Blockchain and describe the opportunities of Blockchain for trade finance. We also look at the role of banks in facilitating and financing blockchain-driven transactions.
What is Blockchain?
Blockchain is a distributed ledger technology. In plain English, it is a large, decentralized spreadsheet in which transactions are securely recorded. Everyone in the network owns a replicated version of the ledger. Ownership and transactions are stored in data blocks, each of which is secured by a cryptographic algorithm. The blocks are then linked to each other, which is why the technology is called Blockchain. The algorithm and the linking process ensure that transactions cannot be tampered with, provided that the majority of the participants in the network “agree” on the current version of the ledger.
Public and private blockchains
Although Blockchain can have a large impact on the way transactions and ownership are recorded, it is important to note that there are actually two types of blockchains: public and private blockchains. On a public blockchain, all parties engage with each other directly on a peer-to-peer basis and there is no intermediary. There are also no barriers of entry to a public blockchain. On the other hand, private blockchains do have barriers of entry and a ‘gatekeeper’ who governs the access to the blockchain.
Public blockchains are more resilient to cyber-attacks, but for many networks the lack of privacy is a real issue. We hence expect that most of the near-future applications of Blockchain relevant to trading will be either private blockchains, or a mix of both private and public blockchains. When discussing the implication of Blockchain below, we describe the effects of private blockchains on which all parties to a trade are present (e.g. traders, banks, shipping firms and warehouse operators).
What does Blockchain mean for traders?
To see the impact of Blockchain on the trading community, we look at the opportunities from the perspective of the three activities of traders: transforming goods and commodities in space (logistics), in time (storage), and in form (processing) (Pirrong, 2014).
Opportunities for logistics
Current logistical systems are largely paper-based, and therefore vulnerable to inefficiency and fraud. When a traders ships goods, he receives a paper bill of lading. In order to obtain trade finance, for example through a letter of credit, this bill of lading has to be sent by courier to his bank. This process is relatively slow, but could be sped up if the process is digitalized, for example on a blockchain. An added benefit of Blockchain is the ability to program smart contracts, which can execute payments automatically without human intervention.
Another effect of the vulnerable paper-based process are regular cases of fraud with bills of lading. Often banks have recourse on traders, meaning that fraud is not only costly for banks but also for traders, even in an LC-covered transaction. We expect lower fraud losses for transactions registered on a blockchain. In that case, there can be only one bill of lading for a shipment, which is verified automatically by all the nodes of the blockchain. This means lower fraud losses. Also, banks will need less capacity to check documents, which will translate in a lower cost of LC’s for traders.
We also foresee a large reduction in compliance costs. Currently banks and corporates need to perform a thorough check on their customers (these procedures are known as CDD (customer due diligence) and KYC (know your customer)) to verify that a transaction does not result in money laundering, terrorist financing or export of restricted goods. We know from surveys that, for example, onboarding a new client is so arduous that 30 percent of 722 corporate respondents claim it can take more than two months, while 10 percent answered it exceeds four months. On a blockchain, rather than going through arduous CDD and KYC processes, a bank can verify that a certain party is currently on the blockchain, meaning that it will have undergone CDD by one the banks on the blockchain. This means it can confirm an LC instantly. A lot of costs can then be saved by the fact that CDD and KYC processes only have to be done once.
The benefits we have described above will apply equally to banks financing trade transactions. In a competitive market, this bring down the cost of trade finance. This will have a major impact, as the worldwide LC market was over US 2,8 trillion dollars in 2011 (BIS, 2014).
Opportunities for storage
The most visible recent trade fraud case was the Qingdao case in 2008, which reportedly cost banks some USD 700m, but there are many more cases that go unreported. Fraud, as in the Qingdao case, usually revolves around multiple warehouse receipts being used in multiple trade finance transactions, extracting cash from banks via inventory financing. A current problem is that multiple warehouse receipts can be generated, as warehouse receipts do not constitute title to the goods in question.
Blockchain changes this situation as it can restrict the number of issued (unique) warehouse receipts. Future integration of the digital and analog worlds may even enable the use of unique digital keys to open a warehouse. This ensures that only the owner of the digital key has access to the goods in the warehouse.
Opportunities for processing
When it comes to processing, the benefit of Blockchain is that it stores the complete history of all transactions of titles and assets within a supply chain. This provides benefits for shipping, but also for food security, transparency on environmental and social sustainability, and certification of origin.
In the past few years we have seen a number of food scandals and very recently the widely reported Brazilian meat scandal. Being able to know instantly from which factory or warehouse each pallet or container originates can greatly improve damage control in case food security is at risk. In addition, consumers are demanding ever more detailed information about where their products came from. To be able to offer customers such detailed information, whether it concerns consumer foods, apparel or electronics, will be a major competitive advantage for any global retailer, and therefore for traders too. They will be better able to serve their customers.
A final reason to embrace supply chain traceability is the reduced cost for obtaining a certificate of origin. Many firms shy away from doing the extensive paperwork necessary to qualify for a certificate of origin. When the origin of a certain product is immediately apparent by looking at the supply chain that was recorded on a blockchain, opportunities to reduce administrative costs are very large.
What's next for banks?
Blockchain will create more transparency in the market for financial services. This will intensify competition between banks and reduce prices of financial services. Some commentators have suggested that banks may become obsolete altogether, but we think this is not the case.
Banks have great capacity in risk management and pricing risks and this capacity will remain necessary to establish a market price for the risks that go with financing. As traders will continue to need financing to be able to ship goods, banks will keep fulfilling this role, albeit faster, simpler and arguably, even more secure. Moreover, bank’s competence in KYC and CDD will benefit the users of blockchains established by banks. Taking over this role is by no means easy, as banks play a vital role in Anti Money Laundering (AML) efforts and the prevention of terrorism financing and other fraudulent practices.
Operating a private blockchain with traders, banks, shipping firms and warehouse operators has potential to speed up payments and document handling, reduce administrative costs and fraud, and improve traceability. But Blockchain stands or falls with networks effects and will only be successful if it is adopted widely.