How Smart Contracts Will be an Enabler for Trade Finance
The advent of blockchain technology has disrupted many industries, including transportation, restaurants, real estate, health care, and now trade finance.
Trade finance plays a vital role in international commerce because it facilitates delivery of goods and payment assurance to exporters and importers. These markets have traditionally avoided change and as such, are exposed to malicious attacks. This leaves the trade finance market susceptible to financial crime due to mass-scale decentralization and lack of digitization.
Fraudsters can exploit these vulnerabilities to receive payments more than once because of lack of transparency in receipts
Recent examples of financing fraud include the over $200 million to a group of banks in the Qingdao port metal financing incident, and the $1.1 billion lawsuit against Citigroup because of falsified receivables
As a response, regulatory bodies are tightening the noose around global banks to incorporate more secure trade finance controls. As the scale of attacks against firms increases, so too will the scrutiny by regulatory bodies. This calls for the use of a distributed ledger pilot using smart contracts to minimize the risk of common malpractices such as the duplicate-invoice fraud.
Understanding Smart Contracts
Blockchain technology can be used to store smart contracts, also known as cryptocontracts. These computer protocols are created to verify and enforce underlying contractual obligations such as the transfer of assets or currencies between if certain conditions are met. Smart contracts enable trade finance to occur without the need for intermediaries.
In other words, they make financial institutions like banks redundant. Integrating smart contracts in trade finance will play an important role in streamlining day to day transactions and effectively putting a stop to fraudulent transactions.
Many banks such as HSBC and Bank of America are now exploring distributed ledger technology and smart contracts. Smart contracts address the following pain points in trade finance supply chains:
- Delivery and payment delays because of process overheads
- Lack of transparency into the movement of goods
- Too much effort and resources needed contractual compliance processes and due diligence
In order to fix common loopholes, banks and intermediaries will have to get on board the blockchain train and implement smart contracts to transform their businesses.
How Smart Contracts Work in Trade Finance
- During a purchase, a sale of agreement is set up between the exporter and importer which is then shared with the import bank via a Smart Contract.
- The import bank will review the purchase agreement and draft terms in real time and submit the payment request to the export bank.
- The export bank reviews the payment application and approves it, promptly updating the entire ledger.
- This initiates the transportation of goods from one country to another.
- Upon reaching its destination, the importer will acknowledge the receipt digitally through the smart contract, updating everyone on the blockchain.
- Once the acknowledgement has been received, the blockchain network will release payment from the importer to the exporter through a Smart Contract.
Step 6 in particular needs special mention here. While traditional payment methods like letters of credit (LC) are an effective way to mitigate business risks, they often come with high costs and contractual delays.
Furthermore, LC compliance is based on trade documents instead of the actual delivery of goods. This makes the entire transaction vulnerable to errors because banks may take inaccurate decisions leading to disputes between parties, while goods sit unclaimed at their delivery location.
To mitigate the risks of denied payments, smart contracts can be modeled after LC. This results in the automation of compliance verification based on contract terms and ensures faster payment to exporters. Smart contracts on the blockchain also enable early discovery of discrepancies that can then be promptly addressed.
Exploring the Advantages of Smart Contracts
i) Real-time Review
All financial documents that are linked through the blockchain can be evaluated and approved in real time, thereby minimizing the time it takes to begin shipment. This speeds up delivery and improves logistics.
ii) Increased Transparency
All invoices on the blockchain provide transparent and real-time updates into subsequent short-term financing.
iii) No Need for Third-Party Intermediaries
Banks that facilitate trade finance using Smart Contracts no longer need a trusted third-party intermediary for risk mitigation.
iv) Lower counterparty risk
Smart contracts allow real-time tracking of bills of lading, making it virtually impossible to send money twice on the same shipment.
v) Proof of ownership
Smart contracts make it easier to track the location and ownership of goods.
vi) Lower Transaction Fees
Smart contracts eliminate the need for third-party contacts, thereby reducing further transaction fees.
vii) Regulator Transparency
Regulators can access essential documents in real-time to ensure compliance at all levels.
viii) Easier to Reduce Disputes
Smart contracts make it easier to reduce fraud and disputes to provide delivery and payment certainty and facilitate the flow of trade receivables.
Risk Mitigation Due to Smart Contracts
Risk is a big factor in trade financing, leading to unfavorable financing terms for small businesses. Research indicates that almost 60% of trade finance applications from SMEs are rejected by banks. There is a potential to facilitate more than $1.6 trillion in trade finance, according to estimates by The Asian Development Bank states.
Risks and inefficiencies limit the size of the trade finance market, which is currently valued at $4 to $5 trillion. There is a lot of potential for growth if smart contracts are used to conduct trade finance.
Smart contracts can enable trade finance by reducing friction due to logistical and operational inefficiencies in the trade finance value chain. If properly implemented, smart contracts would be instrumental in optimizing business processes by reducing implementation inefficiencies and redundancies.
Although the potential for disruption is huge, there are multiple hurdles that must be overcome in order to properly integrate smart chains with trade finance. Some of these challenges are related to ensuring adoption and collaboration by all stakeholders involved in each transaction, including banks, importers, exporters, and insurers.
Other obstacles include legal acceptance and regulatory applicability of smart contracts and distributed ledger applications. As a result, smart contract adoption will need more concerted efforts to gain momentum and reach critical mass to drive network efficiencies.