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What is Trade Finance: A Brief Overview
Trade finance is a centuries-old industry that involves international trade or exchange of goods as mediated by financial institutions. In a trade, buyers (importers), want to make sure they receive the right amount and quality of what they are paying for. On the other hand, sellers (exporters) want a guarantee that they will receive the required payment in exchange for their goods.
Other than non-payment issues and creditworthiness, other risks involved in international trade are currency fluctuations and political environment. Thus, to cut risks, buyers and sellers introduce a third player i.e. financial institutions. They serve as intermediaries, financing the transaction to protect the interests of the two players.
In doing so, financial institutions use several financial instruments and products like a trade finance letter of credit. A trade finance letter of credit is a payment mechanism that a bank issues on behalf of the buyer or importing client. The document essentially states that the exporter will receive a specified amount within a given period. But this will only work so long as the exporter also complies with the provided terms and conditions. This, in essence, is how trade finance works. However, a transaction only pushes through if both parties honor the agreement.
The trade finance process flow has remained the same since the Middle Ages. Yet, with technological advancement and digital transformation, comes a renewed interest in the trade finance industry. The focus now is on how new technologies like blockchain will influence trade finance evolution and change the course of how trade finance works.
Trade Finance: History and Evolution
The origins of trade finance are dated as far back as 3000 BC in Mesopotamia. Artifacts reveal that some Babylonian clay tablets contain the oldest examples of letters of credits and promissory notes. Although, before today’s use of finance trade letters of credit, a bill of exchange was the most widespread financial instrument utilized. Contrary to the letter of credits, a bill of exchange is a written agreement or certificate passed between buyers and sellers that ask to pay a given amount on a specified date. Usually, this is also done through a third party. However, this system does not protect trade players.
Furthermore, importing and exporting goods between distant countries became a practice in different parts of the world. Then, in the 15th century, trade of goods such as cotton, wool, and finished cloth was a significant part of medieval England’s economy. From the Roman Empire to Europe to even parts of America, trade finance increasingly gained popularity during the 17th and 18th centuries, especially as long-distance trade garnered momentum.
Back then, garment and textile industries were the ones mainly benefiting from trade finance. Later on, trade finance expanded to other trading businesses as well. From the 18th to the 20th century, London was one of the leading financial centers in the global trade finance industry. London emerged as the world’s money market and financed the transactions between other foreign countries. Most international trades were financed through the bills of exchange and sterling bills being issued through specialized agents in London.
Today, as new technologies develop and are introduced, trade finance is becoming more strategic to meet the challenges that the traditional system entails. Thus, intending to develop solutions, many companies, including small and medium enterprises as well as large corporations, turn to trade finance digitisation through blockchain technology.
Finance Digitisation and Blockchain: How Did It All Start?
Fast forward to a digital world, several large corporations started adopting digital technologies for their business-to-business supply chain operations. Initially, the automotive and retail industries adopted electronic data interchange systems but this later expanded to other industries as well including healthcare, utility, and pharmaceutical companies. Trade finance digitisation aims to make communication flow faster; this is beneficial when processing purchase orders, invoices, and shipping documents.
Aside from electronic data interchange, the middle of the 20th century to the early 21st century began the installation and management of enterprise software and financial systems, on-premise. In most cases, a third-party developer creates these on-premise systems. This was a conscious effort to improve and quicken trade processes while addressing collaboration issues between trading parties.
Despite these developments, several issues still exist, particularly those around data: privacy, custody, and control. So, to further accelerate digital transformation and to solve related concerns, blockchain or Distributed Ledger Technologies emerged as one of the solutions in trade finance.
In international, cross-border trade, a large volume of information is shared, ranging from product details to transaction documents. With a centralized system, the large chunks of information are even more difficult to communicate. Trade finance on the blockchain, therefore, makes these transactions possible without the need for a trusted centralized authority.
Over the years, blockchain technology has become a buzzword, especially as linked to the cryptocurrency, Bitcoin. This growing interest in the new technology prompted several business players to explore its use and significance to trade finance.
Through blockchain technology, transactions are recorded on a database, which is distributed across various locations and multiple users. Data, then, are stored into blocks with time-stamped records that when linked together form a blockchain.
Considering the challenges of the traditional system of trade finance and the potential uses of blockchain, trade finance is the perfect example of a blockchain application. Connecting key trade players is possible without sacrificing data ownership and privacy. Financial institutions like banks also have superior capabilities for audit and compliance. Transparency and tracking of transactions are inbuilt into trade finance blockchain-based operations. Moreover, the process flow is faster with the presence of a decentralized system.
To state a production-grade example, dltledgers Pte Ltd is a blockchain company that digitised cross-border trade and trade finance processes. the plug-and-play platform ensures that transaction history and is solely visible to permissioned members of the network, further fostering transparency and trust.
What’s Next? Exploring Risks and Future of Trade Finance Blockchain
The current trade finance system is in dire need of updating. Today's operations between all involved parties are complex, costly, labor-intensive, and inefficient. Processes that can be completed within hours or days take months, further impeding the transaction. In a GTReview, a single commodities transaction by sea, for instance, requires as many as 36 original documents and 240 copies coming from at most 27 different parties. This does not even mention the inevitable errors caused by manual processes.
Hence the use of blockchain technology to improve trade finance operations and solve inherent process flaws is welcomed. Still, in the aftermath of the global pandemic, it has become even more critical to shift entirely from a paper-heavy, manual business to digital.
Several companies have experimented with blockchain applications to simplify the current trade finance process and flow. An example of this are food giants, Argocorp International, and Cargill who were involved in a trade transaction between Canada and Indonesia during the COVID-19 pandemic. Both Argocorp International and Cargill were facing issues with the courier network and many of their employees working from home had slowed down operations. As a result, they sought blockchain technology to perform the trade and got onboarded onto the dltledgers blockchain platform.
They reaped the following benefits:
- First-ever, end-to-end, cross-continental trade involving several parties.
- Faster processing and delivery of trade documents (processing speed of documents cut in half).
- Reducing costs through document digitization.
- Increased security and transparency through shared transaction details across involved parties.
The case of Argocorp International and Cargill is just one example showing how blockchain application in trade finance can reduce inefficiencies and costs, and further open better opportunities for partnerships. Financial institutions that facilitate trade finance do not need a trusted intermediary to assume risks. Again, the move to a blockchain technology does not require a centralized system, making the entire process flow available in real-time.
However, despite promising results, there are still some drawbacks to this system. For example, trade transaction information will only be transmitted and communicated between parties through a Distributed Ledger Technologies if all those who are involved use a digital blockchain platform. Otherwise, sharing trade transaction information will not be feasible.
How Will the Trade Finance Blockchain Potential be Fully Realized?
There are multiple stakeholders involved in a cross-border trade transaction (financial institution, the importing and exporting companies, insurers, logistics companies, electronic invoicing, and technology providers). Only if all these trade finance players consciously make an effort to participate in trade finance blockchain initiatives, will legislative, governance laws and regulations be crafted. However, it is easier said than done. If one party in the value chain of trade finance refuses to adopt the blockchain platform for trade finance, this will result in the entire ecosystem not being able to benefit from the technology. Thus, it's imperative for larger companies and financial institutions to adopt the technology first and assert a level of influence in the chain of command to utilize blockchain technology.
Therefore, the mass adoption of blockchain technology is essential in trade finance to unlock its full potential. The future for blockchain technology and the trade finance industry is exciting, to say the least.