May 10, 2018

From supply chain to blockchain: Where can digitization make a difference in international trade?

Modernisation and automation of global trade is a journey that has an inevitable destination. However, in a market sector which needs to continually introduce logistic and administrative improvements to maintain profit margin and increase competitiveness there still remain too many practices that date back to the age of sail and steam.

The reasons for this slow pace of change are complex - partly it is due to the need to change old legal rules and conventions that took centuries to achieve international consensus - but the impact of digital disruption on working practices in some countries and the ability of some economies to adapt is also having a braking effect.

International trade and its financing relies on a series of inter-dependant contractual events and third party confirmations of performance coming together to prove that goods have been produced, shipped and delivered and that payment has been effected. It is a system that evolved by parties becoming comfortable with exchanging pieces of highly valuable paper: bills of lading that acted as title documents to cargos of shipped goods; typed letters of credit and bills of exchange which permitted sight and deferred payment; various certifications of performance from trusted third party service providers; and policies of insurance. It was an imperfect system relying on trust between parties, experience of trade and money flows and appetite for risk. In some countries the administration of this 19th Century process is highly labour intensive - sometimes to provide checks and balances, but often because the community has become used to the system providing employment to a wide group of people even in an age where most people own a smart phone.

The international trade business has been 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, and to provide a digitized solution to the paper chain of trust that traders and bankers have long relied upon to act with confidence in buying, selling, transporting and financing goods internationally. Blockchain has become something of a buzzword in trade finance circles over the past 24 months as solution providers jostle to be first with a workable blockchain solution to the trade's multiple inefficiencies.

Blockchain, in layman’s terms is a technical solution to the gathering of multiple third party confirmations of events and facts surrounding a particular transaction that can provide the key transaction parties with assurance that their counterpart’s performance of the contract has occurred and that the transaction has completed. What might have been achieved in former days by making a dozen phone calls or participating in a dozen meetings and exchanging multiple pieces of paper could be achieved by a dozen secure and authenticated electronic record “blocks” being “chained” together to provide incontrovertible proof of contractual performance.

The low hanging fruit in international trade that blockchain developers have identified as suitable for modernisation is the documentary credit. However, even this highly inefficient area of international trade has not proved easy to change.

Although the first proof of concept blockchain LC transaction took place in September 2016 and internationally agreed rules for electronic documentary presentation have existed for over 15 years, the reality is that in 2018 the vast majority of all LC transactions are still executed using paper.

However, despite every effort, establishing a globally accepted digital alternative to the paper bill of lading has proved a very 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 globally to introduce legislation into a constantly evolving and highly technical sector and (b) the difficulty in persuading 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’ their standards and technology which they feel embodies their USP.

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 - ultimately passed on to the consumer. 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 operational risk and default of performance, increased security and avoidance of fraud and standardisation of contract terms are all benefits achievable by digitization. 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. Document checking and the "5 day" rule for inspecting documents could become a thing of the past if the market embraces automation fully.

An automated process that could address some or all of those issues should have significant value and support.. In a current paper LC transaction, the paper trail fulfils that function, but often imperfectly and not without the potential risk of fraud. The blockchain verified information could, in addition, 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 or activation of a contract - or the issuance or satisfaction by payment of a payment instrument, such as a letter of credit..

In the performance of contracts generally, parts of the process ought to follow automatically once conditions precedents have been met. Introducing automation of such steps need not be controversial. Blockchain driven solutions can in fact do as much or as little as the parties want them to, depending on the goal to be achieved and is more likely to take hold if the goals set for it are realistic ones.

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 “commoditizing” a business under some pressure can frighten some participants. Will the introduction of a disruptive technology such as blockchain expose the parties to greater risk of loss and/or lack of control. Some parties enjoy the ability/flexibility to stray off the contractual path when the opportunity presents itself – particularly where the path of contractual performance can be affected by events outside the parties' immediate control such as weather, strikes etc.

  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. With or without Brexit, compliance is here to stay and blockchain solutions providers will have to work with the authorities to find out what can and cannot be achieved.

  3. he lack of global standards for this sort of scheme makes like for like comparison between solution providers difficult – this has in turn created the appearance of a solution overload with a sometimes baffling choice to market participants. Technology providers naturally want to protect their share of the blockchain cake when it takes hold. However, first the market has to get to like the taste of cake.

  4. There are some tricky legal questions inherent in blockchain and other automation solutions – ensuring that the potential risk of systems failure is covered clearly and that there is an express seat of jurisdiction so that remedies can be pursued against someone if it all goes horribly wrong. As firms across Britain face up to the introduction of GDPR, the issue of data (and financial) security within blockchain systems and the question of who owns the resultant IP and data on any system will be scrutinized.

However, the potential savings are great and banks, traders and other participants 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 is more work to be done. Care has to be taken in ensuring that all parties are able to digitally contract (there should not be a digital gap between rich and poor countries if a real breakthrough in global trade is to be made). There may also 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 18 months.

Electronic settlement of payments and standardising 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 concede some loss of control to the “system” and flexibility to achieve real savings, but that is still achievable without changing the general role of the trader. Dematerialized 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.