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How the blockchain can disrupt trade finance

31 October 2016
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My colleague Immo gave a nice introduction into the blockchain and its capabilities and opportunities in his blog post: Death of the Blockchain – exaggerated?. I would like to follow this up by discussing how the blockchain can foster business-to-business transactions. From my point of view the capabilities of the blockchain are a good fit for enabling business transactions in an environment where companies bring in a third-party as trustee in order to protect themselves. One such environment is trade finance which is likely to face large disruptive changes in the near future. We at Zühlke had several innovation workshops on how to reforge the ecosystem and in this blog post I would like to share my ideas with you.

Role of banks in trade finance

Trade is an exemplary business-to-business transaction. On the one hand there are manufacturers who want to sell their products globally. On the other hand there are buyers who import goods from all over the world in order to keep their businesses running. However, the trade business carries a lot of risk. While the buyer is running the risk to pay without receiving the goods, the seller would be reluctant to ship the goods before being paid. This is where banks come into play. They act as trustee and ensure the delivery of goods and payments, respectively. As such their main mission is to establish trust between untrusted parties. For their services as impartial and loyal partner they will charge fees from their clients. In turn, they have to shoulder payment default risks, i.e. in a worst case scenario they have to reimburse one of the parties. Trade finance provides this assurance and it is a significant source of revenues for banks, totalling about $50B globally a year.[1]

Why banks need to adapt

However, there are changes that put this source of revenues at risk. More and more trades are executed via open account trading, i. e. importer and exporter refrain from consulting banks as trustees. One reason for this change is the discipline of repeated transactions. Importers seem trustworthy if they imported a great deal of goods over an extended period of time. In addition to that, companies want to protect their global brand and violating trade agreements would be counterproductive. And last but not least, the introduction of trade agreements and case laws create more confidence.

How banks can change

How can banks react to these changes? In order to attract customers they have to extend their value proposition, reduce the time-to-money and offer their services at a lower price. The issue with trade finance is that there are a lot of manual, labor-intensive processes, involving different stakeholders and documents. Let us have a closer look at the trade ecosystem (depicted in the image below). If two parties want to execute a business transaction, the buyer will approach his bank in order to receive a letter of credit (LC). The bank will send the letter of credit to the seller’s bank. It is only when the seller receives this letter that he will ship the goods which again includes several external parties and the signing and exchange of documents. If banks managed to reduce the costs of these labor-intensive processes, act as a collecting agent, assuming responsibility for the exchange of goods and documents and reduce the time-to-money significantly, they would be in a good position to increase their market share.

Overview of the trade finance ecosystem

Overview of the trade finance ecosystem

How the blockchain could address these challenges

The blockchain seems to be a good fit to eradicate some of the painful actions involved in the trade process. Since the blockchain is a distributed ledger where each participant stores the immutable history of all transactions that have been executed locally, no central ledger is required any more.

Smart contracts could replace the long-running avalisation process. A smart contract is a piece of software that contains rules that have to be fulfilled before a transaction is executed. It is only when these rules have been verified automatically that the relation transactions are executed. The verification is done within a short amount of time, therefore reducing the time-to-money significantly.

The traceability associated with the blockchain can provide assurance and authenticity of goods. Since the blockchain is an immutable list of transactions, you can at any time trace back where the goods have been obtained, produced, manufactured and processed. Hence, in a trade finance ecosystem based on blockchain, certificates of origin, bills of lading or bills of origin would become obsolete. On top of that the ever-present risk of fradulent documents would be eliminated.

In order to reduce operational costs open APIs should be provided to integrate the blockchain with the companies enterprise resource planning systems. This fosters straight-through processing (STP) and offers the possibility to execute transactions automatically, once the rules of a smart contract have been fulfilled. It would be possible to transfer funds from one account to another and initiate the transfer of goods.

How banks can benefit from the blockchain

The last paragraph may have created the impression that the blockchain is a major threat for existing banks since their role as central ledger is put at risk. However, if banks act as a platform supplier, providing the ecosystem based on blockchain technology for external counter-parties to connect to, there is a good chance that they could even improve their market share. Furthermore, such a platform would offer the means for providing information in near-realtime as well as allowing for increased transparency. In addition to that, for small and medium-sized enterprises banks may provide an enterprise portal in order to access the blockchain ecosystem. Apart from accessing transactional data, the portal could add value for its customers by supplying complementary services, such as forecasting and benchmarking tools. If all these ideas were implemented banks would become the service provider across the whole trading lifecycle.

„Experience an executive innovation evening with Zühlke on December 5”
Is the Blockchain technology mature enough to be used in real world projects? This question was leading us to a proof-of-concept project. During the last months we developed a smart contract application based on Blockchain. If you are interested in learning more about the projects and the lessons learned, please contact us directly (Philipp Harrschar). On December 5, we will hold an executive innovation evening presenting the results.

 

Sources

[1] bcg.perspectives: The Digital Revolution in Trade Finance

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