Exploring the potential and challenges of blockchain technology in the field of traditional trade financing

This article was published on Block Chain Zone, author: Haitham Youssef.

Trade finance has seen significant developments in recent years, especially under the impact of the pandemic, with a clear trend towards the online transformation of trade finance operations. Many countries are exploring the application of blockchain technology in trade finance. In November 2020, Trade Finance Global published an article discussing the potential benefits of using blockchain technology for trade finance activities, highlighting the significant challenges faced in adopting blockchain. The core content of the paper has been compiled by the Institute of Financial Technology at Renmin University of China.

Traditional Trade Finance Systems

Trade finance is used to facilitate transactions between buyers and sellers in different countries around the world and has become the lifeblood of international trade. Trade finance provides the necessary credit, payment guarantees, and insurance to facilitate transactions under conditions satisfactory to all parties. However, traditional trade finance has a significant pain point: the reliance on a large number of paper documents, with most trade finance activities involving the physical transfer of documents among participants such as importers, exporters, banks in the importing country, banks in the exporting country, shipping companies, consignees, and freight forwarders.

Data and Documents Required for Trade Finance

This reliance on documentation is often inefficient, consuming significant costs and time in the preparation, transmission, and verification of these documents. Paper documents are also prone to errors and can even be forged.

Moreover, the outbreak of COVID-19 has profoundly impacted trade finance operations, with many businesses that should have been conducted offline forced to halt or shift online. Today, financial institutions around the world are attempting to deploy their digital initiatives, and many banks are seeking to streamline trade finance processes and reduce costs by creating digital ecosystems.

Potential Benefits of Blockchain for Trade Finance

There is a general optimism regarding the application of blockchain in trade finance. Many industry practitioners believe that blockchain technology can reshape the processes of cross-border trade and related financial services.

Blockchain technology has the potential to change business processes to reduce operational complexity and lower transaction costs. It combines various computing technologies, including distributed data storage, peer-to-peer transmission, consensus mechanisms, and cryptographic algorithms. Essentially, it is a distributed database that can autonomously maintain a growing chain of transactions, with these transaction records stored in units called blocks. Each block contains a timestamp and a hash link to the previous block to prevent tampering. In a blockchain network, decentralized agents or institutions can jointly record and maintain information without any party exerting sustained market dominance or control. The fundamental idea of blockchain technology is to decentralize data storage so that such data cannot be controlled or manipulated by central participants.

Blockchain can potentially enhance transaction transparency and traceability in the supply chain. Trade finance practitioners also indicate that the use of blockchain technology will lead to a paperless trade finance business, quickly delivering error-free documents to clients, thereby reducing printing and verification costs. Furthermore, since blockchain allows all authorized parties to access key documents anytime and anywhere, it can reduce the manual synchronization processes of paper records and bilateral emails.

Smart contracts are electronic contracts based on decentralized consensus and tamper-proof algorithms, containing a series of digital protocols, including the execution terms and constraints agreed upon by both parties. Smart contracts enable collaboration between parties that do not trust each other without the involvement of intermediaries like banks, and they can trigger payment upon preset events, reducing the risk of errors or fraud and facilitating the efficient circulation of funds.

Various studies have shown that smart contracts can lower the costs associated with collecting and processing information, drafting and negotiating contracts, monitoring and enforcing agreements, thereby allowing for more market-based governance structures in certain cases.

Initiatives to Apply Blockchain Technology in Trade Finance

From a developmental perspective, the application of blockchain technology in trade finance is still in its early stages and requires further research to enhance its efficiency and security. Currently, some commercial institutions have established their own blockchain laboratories or are closely collaborating with blockchain companies and have published a series of studies on the subject.

In 2016, Barclays collaborated 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 transaction. In 2018, HSBC announced that it had completed a trade finance transaction using blockchain technology to issue a fully digital letter of credit, with HSBC Singapore acting as the issuing bank and ING Geneva as the designated bank. In 2020, Standard Chartered and DBS Bank Ltd jointly announced that they had launched a project that would connect trade finance transactions of 12 other banks using a blockchain network, including ABN Amro, ANZ, CIMB, Deutsche Bank, ICICI, Lloyds, Maybank, Natixis, OCBC, Rabobank, SMBC, and UOB. Additionally, DBS Bank and Standard Chartered announced that they would further collaborate with the Association Banks of Singapore to expand blockchain trade finance registration globally to cover major trade corridors.

In addition to traditional financial institutions, some technology companies are also working towards the application of blockchain in trade finance, with IBM being one of them. In 2017, IBM collaborated with Maersk on the Hyperledger Fabric project and built an end-to-end digital supply chain model using blockchain technology, involving trade parties as well as various ports and customs authorities. Subsequently, several large banking consortia have partnered with technology providers like IBM Hyperledger or R3 Corda to develop blockchain products and advance the implementation of multiple projects.

Challenges of Blockchain Applications

Despite the ultimate goal of achieving full digitization and automation, it may take some time to realize this goal. Currently, the promotion of blockchain technology in trade finance is slow, primarily due to the following four reasons:

Lack of Standard Protocols for Blockchain Networks

Even within the blockchain community, there are different coding languages, consensus mechanisms, and privacy protection measures, leading to different blockchain platforms becoming isolated islands that cannot connect with each other. Platform developers and participants should avoid fragmentation and enhance the interoperability and standardization of various blockchain platforms.

To achieve the expected benefits of blockchain technology in trade finance scenarios, all ecosystem participants (including trading companies, logistics and transportation companies, banks, and customs) need to agree on a unified 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.

Legal Recognition of Some Digital Documents

A significant challenge facing the entire trade industry in adopting blockchain is the uncertainty regarding the legal status of electronic documents within legal systems. 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 used for trade activities.

The ICC Banking Commission conducted research on relevant laws in ten jurisdictions, including the UK, the US, Germany, the Netherlands, the UAE, China, Singapore, Brazil, India, and Russia. The report indicated that the legal status of electronic bills of lading remains ambiguous in many jurisdictions.

Therefore, the legal requirements mandating the use of traditional paper documents seem to be a significant barrier to the development of blockchain technology in the trade industry. Only when regulations evolve and recognize the large-scale deployment of blockchain technology can its potential to facilitate international trade be realized.

High Costs of Adopting Blockchain Technology

The costs associated with creating and maintaining blockchain networks are considered a barrier to the widespread application of this technology. The high costs of blockchain are typically caused by several factors: first, blockchain networks rely on high computational power, consuming a significant amount of electricity to operate, and requiring substantial computing power to validate and process transactions and secure the network. Second, each node (device) needs to synchronize with other nodes on its own data copy, which incurs costs. Third, the costs associated with companies changing their existing systems; in most cases, if they decide to use blockchain, they will need to alter their business processes or information system designs, leading to higher costs.

Information Transmission and Privacy Issues

Due to the design of blockchain, there may be some fundamental privacy issues. When applying blockchain to trade finance operations, typically, trade parties (such as carriers, exporters, importers, and banks) are able to share a distributed ledger for trade finance transactions. This means that every party involved in processing transactions and building the blockchain can access the blockchain transaction data, which may contain some confidential information. Therefore, it seems necessary to re-model the features of distributed ledgers to allow for restricted access to data, ensuring that only authorized participants can view this data.