Research | How Blockchain Solves Financing Problems

Overview

Under the epidemic, a large number of companies are struggling to maintain their operations. According to the report in the "China-Europe Business Review", the cash balance on the books can maintain the survival time of the enterprise. Up to three months, only 9.96% of companies can maintain more than six months.

According to World Bank data, foreign trade accounted for 38.25% of China's GDP in 2018. According to statistics, the number of domestic-funded enterprises with foreign trade rights in China has increased from more than 6000 in 1989 to more than 400,000 now, and most of them are small and medium-sized foreign trade enterprises. According to the survey, 100% of small and medium-sized foreign trade enterprises have trade financing needs, and trade financing is also an important source of cash flow for more than 50% of small and medium-sized foreign trade enterprises.

In this article, we will outline the general advantages of blockchain systems and demonstrate that blockchain can help trade finance.

Report

Difficulties in trade finance

In 2017, US $ 15.5 trillion of merchandise exports were shipped worldwide by sea, air, rail and road, with up to 80% of global trade requiring financing.

International trade can be conducted through banks as intermediaries (such as letters of credit), or directly between buyers through account opening. Although most global trade flows are conducted through open accounts, companies in Asia and the Middle East make extensive use of letters of credit, of which 77% of export letters of credit originate only in Asia. Changes in risk parameters depend on the timing of financing and risk mitigation, and differ between pre-shipment and post-shipment financing. Inefficient trade finance means that banks have rejected nearly $ 1.5 trillion in trade finance needs. In many cases, these trading opportunities are lost. Take a practical example: In a survey of 1,336 companies, respondents reported that in 60% of the cases, their trade finance applications were rejected. Due to lack of sufficient funds, they were unable to close the deal.

However, trade finance is not readily available to everyone in every region. Insufficient supply of trade finance to emerging markets and SMEs has been an unsolvable problem. This directly affects the ability of emerging markets to benefit from trade-driven growth.

Secondly, many people believe that digitalization is a solution to problems such as lack of transparency, low profit margins, and KYC. Although digitization has changed the way trade finance entities process information, these benefits have not formed an Internet network globally. If every node in the trade finance network maintains its own proprietary source of information, as it does now, then every step of the process requires checking and re-entering the digital document. Let many different centralized systems create localized data centers across the globe that are not interoperable with the wider network. Digital improvements to non-digital infrastructure can only end here. In order to effectively change trade financing and resolve the shortfalls and gaps in trade funds, a fundamental restructuring of the system is needed.

Over the past two years, the advent of blockchain has provided a completely different solution. Blockchain technology provides an open technology layer that allows programs to connect and expand. The distributed architecture of the blockchain can serve as a better foundation. Trade finance is inherently decentralized. By changing the structural basis of trade finance, the technology offers opportunities to bridge the gap in an unconventional manner. Sharing decentralized, trusted, and secure records of information among interested parties can reduce friction while maintaining the efficiency of trade.

This article uses a design approach to explore whether blockchain can restructure trade finance and make it more inclusive. This method is unusual in that we directly map the cause of the trade financing gap to the characteristics of the technology itself.

Although public blockchains like Bitcoin are most familiar to ordinary readers, we focus on enterprise blockchains in this article. We believe that licensing blockchain is the most suitable solution for trade financing. Trade finance is highly regulated, cross-jurisdictional, and involves the secret exchange of information by multiple parties. In this article, we will outline the general advantages of blockchain systems and demonstrate how blockchain can help trade finance. As blockchain technology transitions from proof-of-concept to practical application in 2018, we can gain an in-depth understanding of whether the technology will eventually narrow the trade financing gap. We will explore the impact of blockchain on three basic causes of the trade financing gap: compliance costs, profits, and information. Our goal is to prove that the benefits of blockchain technology in trade finance can not only improve operational efficiency, but also effectively reduce the market gap between frontier markets and SMEs.

Status of trade data

Strong data storage centralization

In today's trade finance, each party has its own database. It is highly unscientific that trade information is repeatedly shared, checked for differences, verified and updated. First, the cost of verification and inspection is high. This is because every entity in the trade needs to ensure that the documents they receive meet regulatory requirements. These entities also need to confirm what they want to see about the transaction-whether the goods in the purchase order are the same as the goods in the invoice.

Second, trading companies rely on agency restrictions. The bank-to-bank (agent) relationship is the core of the current trade financing system. In the past few years, however, thousands of agency relationships have been severed due to cost and regulatory factors. This reliance on a network of correspondent banks limits the flexibility of trade finance.

Local or private banks most likely to establish banking relationships with SMEs may not have the necessary network of agency relationships to facilitate international trade transactions. A global bank reports that the cost of performing a due diligence on a bank is approximately $ 75,000. In recent years, when global banks began to break away from agency relationships, it was mainly emerging markets that were cut off.

Finally, although the use of cloud computing is increasing, the pace of deploying new digital solutions remains slow. However, considering recent hacks that have received much attention, it is clear that no matter how carefully you isolate your data, centralized data storage is vulnerable.

Gap between emerging markets and SMEs

The way data is shared in trade today exacerbates the challenges inherent in emerging markets. ADB estimates that the global trade financing gap in 2017 was $ 1.5 trillion. In addition, 40% of global unmet trade finance needs are concentrated in Asia Pacific and Africa.

However, the problem is not just geographical. SMEs in each jurisdiction face deficiencies in obtaining trade finance. The bank reports that 74% of SME applications for trade financing are rejected by them. Small and medium-sized trading companies around the world have reported that a lack of trade finance is one of the main constraints on their business. Globally, their screening costs are higher and financing rates are higher. Smaller exporters are subject to higher credit restrictions than larger companies, which has reduced the scope of transactions or prevented small and medium-sized enterprises from entering the export business.

Problems that blockchain can solve

When investigating why banks rejected trade financing, their feedback on these SMEs applying for financing fell into three broad categories: lack of adequate information, low profits, and KYC issues. In the final analysis, the information is not transparent enough that banks cannot predict and perceive risks.

Digitization has made significant progress in all of these areas. Regtech is committed to automating KYC reporting, fintech solutions have created new sources of information to evaluate companies, and digital initiatives have focused on reducing trade financing costs. Each of these has important potential impacts on all aspects of the trade finance process.

Although digitalization attempts to solve some problems, it also exacerbates the root causes of the problem in other ways. As banks implement new digital solutions, the number of platforms has exploded. In other words, platforms are not interoperable. As long as all parts of the transaction are on the same platform, the digital solution will work. In global commerce, a transaction may involve the interaction of 20 entities, 100 documents, and 5,000 data fields. Vertical digital solutions make the problem worse because they cannot interact with the data smoothly.

Enterprise blockchain aims to solve these difficulties interactively. The enterprise implementation of blockchain technology can better meet the data privacy requirements of international trade because they prevent all information from being publicly broadcast to all parties. In addition, depending on the architecture, they can address the scalability limitations of public blockchain systems.

Does the blockchain have the ability to reduce the trade financing gap?

If today's trade finance architecture enables the financing gap to persist, does this mean that restructuring the technology of trade finance will reduce the gap? There are many things to be clear about this argument. Although we hope that the trade finance application built on the blockchain platform can achieve this goal, the scope of different applications is too large to evaluate the details of each individual.

In this section, we do not focus on the prospects of blockchain applications, but discuss specific technical mechanisms. So, does the technology have or have the ability to address the trade financing gap?

Our goal is to provide a specific discussion around blockchain technology to see how we can address the concerns of banks that lack sufficient information, low profits and KYC.

Low profit

Low profits come from two sources: the cost of a bank processing a transaction and expected revenue. Since the transaction volume and frequency of SMEs may be lower, their expected profits will naturally be lower.

Due to the diversity of participants and steps involved, the cost and time to process a trade transaction can be significant. Much of the cost comes from the extra effort required to delay, friction, and process trade data. Trade finance is a linear process that relies heavily on paper documents, which we have mentioned in previous reports. Written documents are shipped with the goods from one port to another, inspected, signed, and faxed to all parties, and almost no single participant can see the entire process. Manual inspections are time consuming and error prone. Because no party has full control or visibility into the entire process, many emergencies occur.

Delays can have real cost implications. Taking demurrage as an example, this refers to the fee paid to the charterer for failing to load or unload cargo within the agreed time. These costs add up to $ 150 per container per day in the United States. This may not seem like much, but if used on an entire ship, such as a Panamax, the cost of delay is $ 750,000 per day.

These costs are compounded by banks and companies that lack direct agency relationships. For small and medium-sized companies, the time, errors, and correction errors required to execute a transaction, as well as the need to verify all parts of the transaction due to the need to establish the source of the document, resulted in low profit margins.

solution

Blockchain can solve this problem. The starting point is 1) a single truth layer 2) automated processing 3) Oracle and (4) multi-signature. Because the parties can trust that the information they see is the same as the information seen by other parties, the confirmation process is greatly simplified. A major cost in a trade transaction is that the same document is passed back and forth multiple times. For example, a letter of credit usually has 19 steps to process. By using a truth layer, we can eliminate seven of these steps immediately. With the blockchain, all parties can be confident that the information on the screen is verified and the same as what their opponents see on the screen. The data is accurate and reliable from the start. Sharing a single source of truth among interested parties can reduce the cost of repeated validation related errors. This will shorten financing time and increase real-time visibility of transactions. Faster information transfer and fewer errors will reduce the additional costs associated with high-risk transactions.

The second method of blockchain to solve the problem of profit is to automate some steps that currently have a long lag time. Only an automatic update system is required to automatically update to a state shared between parties. Oracle and third-party signatures are two examples of blockchain inputs that can trigger automated processes. Oracle is an agent on the blockchain that provides information to participants in one or more business networks. They obtain information from real-world events, third-party data providers, or other blockchain activities. Oracle can push information to the business network on a regular basis or on request, not just one party to the transaction.

In trade transactions, ownership of the goods changes throughout the process. The title document (eBL) allows the holder to take ownership. After the goods are ready for shipment, the shipper requires the carrier to issue a bill of lading. The consignor exchanges eBL's goods with the carrier. The shipper then submits an electronic bill of lading to the advising bank to meet the documentary submission requirements of the letter of credit. Because each eBL is associated with a unique ownership registration record-which is maintained by Oracle-therefore, ownership is transferred from the shipper to the advising bank only after querying Oracle for confirmation of the registration record number.

Trusted third parties can also provide signatures to the blockchain. For example, when the goods arrive at a port, the carrier may send an invitation to pay after signing to automatically trigger the next process to eliminate friction. Once the physical goods are checked and the data is entered into the system, the smart contract can immediately transfer funds from the seller's bank to the buyer's bank. This can significantly reduce the delay between the inspection of the goods and the final release of funds.

Lack of information

The second reason for trade finance rejection is the lack of reliable information. This makes it difficult for stakeholders to accurately measure risk, which is more complicated for SMEs. When risk is the result of asymmetric information, blockchain can improve risk management. It can help answer questions such as: Can this SME perform its contract? Is it capable of providing high-quality goods / services within the contracted time? Will it still be solvent while fulfilling its obligations?

solution

Recording transactions on the blockchain can generate a large amount of metadata, and financial institutions can reliably and effectively answer questions related to SME performance and risk from this data. If all transactions of SMEs are gradually acquired through the blockchain, then this information can be organized to solve the root cause of the SME financing market gap. In addition, the ability to determine the legal entities of the transaction participants is the basis for effective trade finance.

KYC issues

Regulation plays a key role in the functioning of the global financial system. Over time, the diversity of regulations and the scale of sanctions fines have increased. This involves a third major reason for rejection of trade finance proposals-KYC and AML issues. The cost and complexity of regulatory compliance play an important role in transaction costs.

Enterprise blockchains can address compliance-related uncertainties through three characteristics. These include real-time sharing of information through supervisory nodes, proactive supervision by requiring certification from third parties that have undergone KYC inspections, and more retrospective analytical data that may help more effective supervision. In addition to the ability of the blockchain to enhance the reliability and efficiency of KYC and AML due diligence, the technology can also address two related regulatory issues. The first is uncertainty from regulators. Because regulators see transaction data only after the transaction has taken place, they have shifted the burden of supervision onto banks due to a lack of insight. The second is the uncertainty of banks. Every bank needs to meet different levels of regulatory requirements.

In the port of Qingdao, China, multiple banks and trading companies each hold different ownership of the same metal, which leads to the potential for fraudulent transactions.

solution

Blockchain technology has the potential to address some of these fraudulent transactions. For example, a notary can ensure the uniqueness of an invoice or payment, thereby solving the double spend problem. Because transactions are represented as a specific state, it is mathematically impossible to reuse the same state multiple times. That is, if a specific invoice has a specific number, the same asset cannot actually be sent to two banks-it can only be used once.

Although this does not prevent people from creating two separate invoices with different numbers, the bank can ensure that a certain status is used only once in the same application. As regulations surrounding trade finance continue to increase, sanctions for violations have also increased. According to FinCen, the number of suspicious activity reports increased exponentially from 1990 to 2013. In addition, market participants must regularly generate compliance reports and submit them to relevant regulators. Much of the work is still manual, which results in high overhead costs. Enterprise-level blockchains allow specific types of entities to be added to transactions, which we refer to as adjustment nodes. This tuning node can be incorporated into the network and it can monitor transactions as they occur in real time, but does not allow them to change transactions. This reduces the need for manual regulatory reporting and can significantly reduce costs.

Blockchain addresses the cost and complexity of regulatory compliance in an unusual way. Although existing regtech solutions focus on simplifying KYC, this is only part of a complex problem. By allowing regulators to have a direct understanding of the transaction, the reporting process can reduce the burden by incorporating it into the transaction itself.

Conclusion

Blockchain will influence the way trade finance is financed. As banks and businesses move transactions to the blockchain, it will become faster and more secure.

Does this mean that blockchain will solve the trade financing gap? I think it depends on whether it can be applied at scale.

2018 is the year when the proof of concept enters the pilot and production stages. As we learned during the design phase, trade finance issues will be much harder to solve than they seem. With the continuous development of trade, financial institutions are not only able to provide the types of financing needed today, but also the types of financing needed tomorrow, but whether consensus can be reached that requires the use of blockchain solutions lies in the various participations in international trade Side work together.

risk warning:

  • Beware of illegal financial activities under the banner of blockchain and new technologies. The standard consensus firmly resists the use of blockchain for illegal fundraising, online pyramid schemes, ICOs, various variants, and dissemination of bad information.