March 21, 2018

Blockchain in international trade execution

Digitalization of global trade is a journey that to some extent has an inevitable destination. Like the introduction of the first machines into the textile industry in 19th century Britain, the shock of change, perhaps even the impact on labour may cause voices of dissent to be heard alongside the cheerleading for modernisation and scalable efficiencies.

One thing is certain, however, and that is the general direction of travel which will almost certainly “commoditise” further the commodities and other international trade sectors by introducing transparency, standardisation of contractual terms and demystification of the art of negotiating and executing at least some aspects of the international sale, movement and payment of goods and services.

The driver for change will be both the efficiency brought by reducing reliance on labour intensive data processing, contract confirmation and other administration and the elimination of costly and wasteful human error in both contracting and payment settlement – possibly further elements of the contract chain too. Unlike the Luddites who protested the industrial revolution’s steady march by vandalising the newly delivered machines, no computer bashing is anticipated to mark the introduction of blockchain and other technological advances into the world of international trade.

Unlike the 19th century weavers and other affected workers, traders are unlikely to see their jobs dematerialise alongside the paper documents that are seen as part of the problem dragging an anchor behind 21st century trade. There is much more to successful trading in the commodities markets than the churn of contractual documentation and the mundane aspects of contract execution and payment – all areas fraught with operational risk. Human beings will for some time to come be seen at the centre of trading relationships but supported by machines. Some jobs will doubtless be “right-sized” in this process as will be seen across different industries.

The international trade business has bene looking at how to introduce technology both to speed up and to improve accuracy in certain aspects of trade execution and settlement for around 25 years. The first incarnation of the Bolero project in 1995, the introduction in 2002 of the first version of the eUCP regulating electronic performance of documentary credit obligations and subsequent ventures into paperless trade including GlobalTrade and ESSDocs are part of a string of well backed initiatives to take the execution of international trade out of the 19th century and into the present.

Although the first proof of concept blockchain LC transaction took place in September 2016 the reality is that in 2018 the vast majority of all LC transactions are executed using paper. In this respect, vanilla international trade and trade finance has lagged behind international receivables finance benefiting from certain legal and commercial advantages which trade at large does not share. While the statutory provisions governing the legal sale and assignment of debt are still governed in principle by legislation dating back to 1925 which required assignments to be executed “in writing and under hand”, the introduction of electronic signature both in the UK and across developed economies has meant that the process of offering to sell and purchasing multiple high volume low value receivables can now be largely automated and achievable at low cost.

Invoices can now be issued, sold and legally assigned digitally and in a largely automated process – a saving grace for SME’s whose access to the rapidly disappearing trade finance market has been steadily reducing since the introduction of Basel II in June 2004.

However, despite every effort, establishing a global solution to the paper bill of lading has proved a much more difficult proposition. The governing UK statute dates back to 1885 and a range of different uncoordinated electronic solutions have been tested – some on a commercial scale. The problem has been caused by a mix of (a) a lack of political will to introduce legislation into a constantly evolving and highly technical sector and (b) the difficulty in corralling a majority of the world’s traders, banks and governmental agencies to agree a common legal approach. Investors, including trade stakeholders have committed money in various directions unsure which if any system might succeed. Solutions providers have often been reluctant to share with competitors’ standards and technology which they feel embodies their USP. Many solutions have relied on a “club” approach to contracting electronically which has necessarily limited global application – particularly in technologically disadvantaged jurisdictions – many of which are key participants in global trade.

An additional peril facing participants in international trade is that despite contractual agreement that certain processes will be followed through during the performance of a contract, which might include the service of notices or the formal transfer of title, parties either choose not to or simply fail for operational reasons to do what was agreed. Disputes often arise and are an additional unwanted cost. If some, at least, of those processes could be automated that would likely save significant time and money.

The potential gains from the introduction of effective technologies are therefore many. Cost efficiencies, compliance, accounting, speed of settlement, reduction of operation risk and default of performance, increased security and avoidance of fraud and standardisation of contract terms are all benefits achieved by digitalization. In letters of credit just one discrepancy in a paper document can cause a letter of credit not to pay. That still occurs in well over 50 % of LC transactions. The appearance of blockchain or distributed ledger technology has therefore raised hopes that a more lasting and global breakthrough might be achieved and there have been numerous projects taken through to proof of concept stage.

So what is blockchain and how can it achieve these resulting benefits? International trade and its financing relies heavily in places on the degree of trust which exists between the trader and its finance team on the one hand and the financier or contractual counterpart on the other. There are not infrequent inadvertent breaches and occasionally abuses of that trust - in some cases allegations of fraud or forgery.

An automated process that could address some or all of those issues would have significant value. Blockchain is in effect a data base of information related to a transaction which has been verified by a series of unimpeachable and very secure sources where independent parties securely build up the verification of the key contractual components and conditions . In a current paper LC transaction, the paper trail fulfils that function but often imperfectly. The blockchain verified information may automatically trigger the performance of a “smart contract” – a pre-loaded and coded application which can then electronically deliver either a physical contractual step – such as the issuance of a contract - or the issuance or satisfaction by payment of a payment instrument.

In the performance of contracts generally parts of the process ought to follow automatically once conditions precedent have been met. Introducing automation of such steps need not be controversial. Blockchain can in fact do as much or as little as the parties want it to depending on the goal to be achieved.

With such evident advantages why hasn’t this solution for trade and trade finance met with success before now? The reasons are multiple but not all that surprising:

  1. The introduction of a technology which has the effect of further “commoditising” a business under some pressure on margins can frighten some participants. Will the introduction of a disruptive technology such as blockchain expose the party to greater risk of loss or just lack of control.
  2. The regulatory piece in international trade requires individual responsibility for certain compliance risks. Delegating some of these functions to a machine won’t entirely shift that risk.
  3. The lack of global standards for this sort of scheme makes like for like comparison between solution providers difficult – this has in turn created a solution overload with a sometimes baffling choice.
  4. There are some legal obstacle inherent in blockchain – ensuring that the potential risk of systems failure are covered clearly and have an express seat of jurisdiction – who owns the resultant IP on the system – and many more.

However the potential savings are great and banks, traders and other participants and others are rushing to buy a part of their local offering. The opportunity to use blockchain to de-risk certain aspects of trade execution is very attractive.

There are natural limits to what blockchain might do without changes in the law in certain areas but obvious gain areas could include execution of electronic letters of credit, back office contract writing, elimination of contract discrepancies following a deal, trade certification, and ultimately simple contract physical execution and fulfilment.

There is more work to be done. Care has to be taken in ensuring that all parties are able to digitally contract – there may be local jurisdictional rules in play. Slicing and dicing the areas suitable for blockchain/smart contract delivery will also require some legal analysis to avoid gap risk. One benefit may be the standardisation of some trade rules to avoid unnecessary cost and breaches. Commentators estimate that the first arms’ length “on risk” (rather than proof of concept) commercial LC transaction fulfilled through blockchain (and without any paper) may take place within say 18 months.

Electronic settlement of payments and publishing of contracts is of course the low-hanging fruit in terms of efficiencies to be made. The oil trade with its high value cargos and increasingly standardised contact terms and vessel charters is another target under consideration. Traders may have to conceded some loss of control and flexibility to achieve real savings but that is still achievable without changing the general role of the trader. Dematerialised transport documents or at least alternative ways of fulfilling/evidencing the shipment obligation will still require some careful global due diligence – but that project is already underway with the ICC Banking Commission so real breakthrough may not be far off.