Blockchain in Trade Finance: Opportunities and Challenges

This paper discusses the potential benefits of using blockchain technology for trade finance activities and highlights the significant challenges to adoption of blockchain.

Trade finance has seen significant growth in recent years, especially in light of the epidemic, with a clear trend towards online trade finance operations, and many countries are exploring options for applying blockchain technology to trade finance operations. Trade Finance Global, a leading global trade finance platform that has partnered with more than 270 banks and other financial institutions. In November 2020, the platform published an article discussing the potential benefits of using blockchain technology for trade finance activities and highlighting the significant challenges of adopting blockchain. The Institute of Financial Technology of Renmin University of China (WeChat ID: ruc_fintech) has compiled the core content of the paper.

Traditional Trade Finance System

Trade finance is used to facilitate transactions between buyers and sellers in different countries around the world and has now become the lifeblood of international trade. Trade finance provides the credit, payment guarantees and insurance needed to facilitate transactions on terms satisfactory to all parties. However, traditional trade finance has a major pain point in that it uses a lot of paper documents and most trade finance activities involve the transfer of physical paperwork between participants such as importers, exporters, banks in the place of import, banks in the place of export, transport companies, receiving companies, and shipping companies.

Blockchain in Trade Finance: Opportunities and Challenges

Figure 1 Data and documents required for trade finance

This reliance on documentation is often inefficient, consuming much cost and time in preparing, transmitting and checking these documents. Paper documents may also be prone to errors and even forgery.

In addition, the explosion of COVID-19 has profoundly affected the trade finance business, and many operations that should be conducted offline have been forced to discontinue or move online. Today, financial institutions around the world are trying to deploy their digital initiatives, and many banks are looking to streamline trade finance processes and reduce costs by creating digital ecosystems.

The potential benefits of blockchain for trade finance

There is widespread optimism about the use of blockchain in trade finance. Many industry players believe that blockchain technology can be used to reshape the process of cross-border trade and related financial services.

Blockchain technology has the potential to transform business processes to reduce operational complexity and lower transaction costs. Blockchain combines multiple computer technologies, including distributed data storage, peer-to-peer transfers, consensus mechanisms and cryptographic algorithms, and is essentially a distributed database that autonomously maintains a growing chain of transactions stored in units called blocks, each of which contains a timestamp and a hash link to the previous block as a safeguard against tampering. In a blockchain network, decentralized agents or institutions can work together to record and maintain information without any one party exerting ongoing market dominance or control. The basic idea of blockchain technology is to decentralize data storage so that such data cannot be controlled or manipulated by a central participant.

Blockchain can potentially improve transaction transparency and supply chain traceability. Trade finance practitioners also say that the use of blockchain technology will enable trade finance operations to move to paperless and deliver error-free documents to customers quickly as a way to reduce printing and validation costs. In addition, because blockchain allows all authorized parties to access critical documents anytime, anywhere, it can reduce the process of manual synchronization of paper records and bilateral emails.

Smart contracts are electronic contracts based on decentralized consensus as well as tamper-proof algorithms that contain a series of digital agreements, including execution terms and constraints agreed upon by the contracting parties. Smart contracts allow parties who do not trust each other to collaborate without the involvement of an intermediary like a bank, and can reduce the risk of error or fraud and facilitate the efficient flow of funds by triggering the reimbursement of payments through pre-defined events.

Various studies have shown that smart contracts can reduce the cost of a range of processes such as gathering and processing information, drafting and negotiating contracts, and monitoring and enforcing agreements, thereby allowing for more market-based governance structures in some cases.

Initiatives to apply blockchain technology to trade finance

From a development perspective, the use of blockchain technology in trade finance is still in the early stages of development and further research is needed to improve its efficiency and security. Today, a number of commercial institutions have established their own blockchain labs or are working closely with blockchain companies and have published a range of research on the topic.

In 2016, Barclays partnered with a fintech startup called Wave to build a blockchain-based letter of credit project on the Wave blockchain platform, completing the first blockchain-based cross-border trade finance operation. 2018 saw HSBC announce that it had completed a project using blockchain technology to issue fully digital letters of credit for trade finance transactions in which HSBC Singapore acted as the issuing bank for the letters of credit and ING Geneva as the designated bank.In 2020, Standard Chartered and DBS Bank Ltd jointly announced that they had launched a project that will use the blockchain network to connect the trade finance transactions of 12 other banks, including ABN Amro, ANZ, CIMB, Deutsche Bank, ICICI, Lloyds Maybank, Natixis, OCBC, Rabobank, Sumitomo Mitsui Banking Corporation (SMBC) and UOB. Singapore) for further cooperation to expand blockchain trade finance registration business globally to cover major trade corridors.

In addition to traditional financial institutions, some technology companies are also working on blockchain applications for trade finance, IBM being one of them. 2017, IBM and Maersk (Maersk) collaborated on the Hyperledger Fabric project and built an end-to-end digital supply chain model using blockchain technology based on this, which involves trade parties as well as various ports and customs authorities. Since then, several large banking consortia have partnered with technology providers such as IBM Hyperledger or R3 Corda to develop blockchain products and advance several projects to the ground.

Challenges of blockchain applications

While the ultimate goal is to achieve complete digitization and automation, it may take some time to achieve this goal. Currently, the application of blockchain technology in trade finance is spreading slowly for four main reasons.

  1. lack of a standard protocol for blockchain networks

Even within the blockchain community, there are different coding languages, consensus mechanisms, and privacy protections, resulting in different blockchain platforms becoming silos that cannot connect to each other. Platform developers and participants should avoid fragmentation and instead enhance the interoperability and standardization of various blockchain platforms.

For blockchain technology to reap the expected benefits in trade finance scenarios, all ecosystem players (including trading companies, logistics and transportation companies, banks and customs, etc.) need to agree on a uniform set of technical standards and business rules. The ICC Digital Standards Initiative, launched in September 2020 with the support of the Asian Development Bank and the World Trade Organization (WTO), is an important step towards establishing an interconnected blockchain trade finance platform.

  1. Some digital documents are not recognized by existing laws

The significant challenges facing blockchain adoption across the trade industry are also related to the uncertainty of the legal status of electronic documents in the legal system. Currently, most legal systems around the world may recognize the status of paper documents in international trade, but many jurisdictions do not recognize electronic signatures and electronic documents for trade activities.

The ICC Banking Commission has conducted a study of the relevant laws of ten jurisdictions, including the United Kingdom, the United States, Germany, the Netherlands, the United Arab Emirates, China, Singapore, Brazil, India and Russia, and the report shows that the legal status of electronic bills of lading is still relatively ambiguous in many jurisdictions.

As a result, legal requirements mandating the use of traditional paper documents appear to be a significant barrier to the development of blockchain technology in the trade industry. The potential of blockchain technology to facilitate international trade will only be realized when regulations continue to evolve and recognize the large-scale deployment of blockchain technology.

  1. High cost of adopting blockchain technology

The cost of creating and maintaining blockchain networks has been identified as a barrier to the widespread adoption of the technology. The high cost of blockchain is usually due to a number of factors: first, blockchain networks rely on high computing power and therefore consume a lot of electricity to operate, and require huge computing power to verify and process transactions and secure the network. Secondly, each node (device) needs to synchronize with other nodes on its own copy of data, a process that incurs costs. Third, the cost for companies to change their original systems, in most cases, if they decide to use blockchain, they need to change their business processes or information system design, which will bring higher costs.

  1. Information transmission and privacy issues

Due to the design of blockchain, some basic privacy issues may arise. When applying blockchain to trade finance operations, typically, trading parties (e.g., carriers, exporters, importers, and banks, etc.) are able to share distributed ledgers to conduct trade finance transactions. This means that each party that processes the transaction and builds the blockchain has access to the blockchain transaction data, which is likely to contain some confidential information. Therefore, it seems that the distributed ledger features need to be re-modeled to allow restricted access to the data, and only to the participating parties authorized to view this data.

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