by Rebecca Liao
The specters of protectionism, geopolitical competition, and weakening international integration have recently made the underpinnings of global commerce seem insecure. Small wonder, then, that new ways of plugging into the international economy are flourishing.
Among these innovations is blockchain, a so-called distributed-ledger technology that allows transactions to be validated without the use of a centralized database. Blockchain has drawn the most attention for its role as a platform for cryptocurrencies: since its debut in 2008, it has helped spawn more than 800 of them, including Bitcoin. But cryptocurrencies serve mostly as fodder for speculative investments, toys for technologists, and instruments for money laundering. Blockchain’s deeper impact on global commerce will come from its use by businesses and financial institutions. Some are already employing it to digitize contracts, eliminate intermediaries in financial transactions, and make ledgers easier to audit. Because blockchain provides a distributed digital record that does not require trust or coordination between firms, it allows for secure, standardized transactions to occur almost instantaneously, even across borders.
Regulators should welcome these developments. The widespread adoption of blockchain would reduce friction in the global economy—and it would especially benefit importers and exporters, granting them access to the financial backing that many now lack.
Some observers have compared blockchain’s potential to that of the Internet: a transformative invention that could set off rapid change thanks to the breadth of its possible applications. The truth, however, is that many of blockchain’s applications will bring about only incremental improvements. The technology, for example, could eventually help big banks eliminate paper contracts, do away with clearinghouses, secure digital systems from cyberattacks, and quickly settle transactions—changes that could save such institutions hundreds of millions of dollars each year. But getting there will take time, because the existing financial infrastructure has been in place for decades and because it is hard to get competing institutions to cooperate.
For businesses to share blockchain’s benefits in the near term, they need to have a preexisting interest in working together that extends beyond just cutting costs. That is why blockchain has so much potential in the field of trade finance (also known as supply-chain finance). Trade finance comprises the instruments underpinning international commerce—everything from letters of credit (the bank-issued guarantees of payment that importers offer exporters) to bills of lading (the documents that certify the contents of a shipment). The banks and companies that participate in trade finance have reason to cooperate with one another, since they are connected to each other through a common supply chain. (My company, SkuChain, provides blockchain technology for the supply chain, including in the area of trade finance.)
In 2015, the global trade finance sector was worth some $2.8 billion dollars. The total available market, however, is about 10 times that size, according to the consultancy McKinsey and Company. The industry plays a critical role in global supply chains: without it, sending goods across borders would cost much more, and businesses would be unable to obtain the funding they need for their operations.
The trouble is that firms cannot access certain types of trade financing, thanks to regulations and risk. As a result, in 2015 the volume of global trade financing fell $1.6 trillion short of businesses’ needs, according to the Asian Development Bank. The worst affected companies were small- and medium-sized businesses, whose requests for trade financing were rejected by financial institutions 57 percent of the time, compared to only 10 percent for requests by multinational corporations. Because borrowers’ ability to access trade financing depends on the condition of their balance sheets and because there is uncertainty regarding the enforceability of contracts, it is often prohibitively expensive for companies to secure capital.
Companies and banks, in short, have yet to scratch the surface of trade finance’s potential. Unlocking it could reduce friction in international commerce, broaden the distribution of the gains from trade, and encourage higher economic growth. It is here that blockchain has a role to play.
RISK AND REGULATION
There are a few major impediments to the growth of trade finance. The first are the capital constraints introduced by the Basel II and Basel III regulatory frameworks, which were developed by a committee representing the central banks of the G–10 countries in 2004 and 2011, respectively. Basel II and III sought to protect banks’ balance sheets from economic shocks. Yet they have also stifled the ability of commercial banks to secure trade financing.
Start with Basel II. That accord required banks to keep enough capital to cover the obligations from financial instruments for at least a year, in an attempt to better insulate the banking system from economic disruptions. But trade finance instruments, which focus on short-term transactions, tend to mature more quickly than that—an average of some 80 to 147 days after they are issued, according to the International Chamber of Commerce. As a result, Basel II encouraged banks to move away from the shorter-term financing that supports supply chains and into riskier assets with longer maturity periods. (The Basel Guidelines have since exempted some forms of trade finance from this requirement, but many are still affected.)
As for Basel III, it required banks to incorporate financial instruments that had historically been kept off their balance sheets into their calculations of leverage ratios, a measure that effectively weighs a bank’s capacity to fulfill its financial obligations. Trade financing instruments fit that bill, and the result was that the regulation made some banks’ leverage ratios appear riskier than they actually were. The financial services organization BAFT–IFSA estimated that banks’ capital costs for trade financing would rise between 18 and 40 percent when the Basel III regulations first came out, without a commensurate increase in returns. Naturally, banks prefer to have higher-yield assets on their books; as a result, the rule suppressed trade financing. (In January 2015, after a backlash from the trade-finance industry, the Basel Committee ruled that banks would have to account for only 20 percent of the value of trade-finance instruments when calculating leverage ratios, but that change has been implemented unevenly.)
Then there are so-called anti-money laundering and know-your-client regulations, which seek to provide international standards for the prevention of financial fraud. These impede trade finance by making the process and paperwork involved in executing transactions more arduous. Counterparty risk (the risk that a buyer or seller is not financially sound) and performance risk (the risk that a party will fail to fulfill its contractual obligations) are the other limits on trade financing. High levels of these risks make it costlier for financial institutions to issue letters of credit and other financing instruments.
Banks are already working to digitize their trade-finance transactions to reduce costs and boost security. Some, for instance, are creating consortia that will standardize and integrate the activities of financial-technology firms. Such changes could produce cheaper, faster, and safer transactions. But those benefits alone are not enough to overcome the main source of the deficit in trade financing: risks and regulation of the kind introduced by Basel II and III.
There are two main ways that blockchain could help firms overcome those problems. First, blockchain introduces deep security. Not only does the technology allow for the digitization of contracts and other paperwork, it can grant secure digital identities to the goods themselves, eliminating or at least accurately detecting performance risk. Next, it lets the firms involved in a transaction input and receive data about goods in real time without integrating their respective digital infrastructures. All of that increases the information at firms’ and financial institutions’ disposal, enabling transactions that would otherwise carry an intolerable amount of performance risk. The certification of firms’ fulfillment of their contractual obligations on the blockchain also nearly eliminates counterparty risk. These benefits are out of the reach of shadow banks and digital trade-finance platforms, the existing institutions that seek to reduce the barriers to trade financing. Blockchain thus provides companies and banks a way to undo Basel II’s and Basel III’s retarding effect on trade finance while complying with their requirements. (The technology won’t transform anti-money laundering and know-your-client regulations, however: those rules are internationally mandated, incorporated into the banking industry’s compliance practices, and would require a major global effort to reform.)
The first international trade-finance transaction on the blockhain occurred in October 2016, when Brigghann Cotton, together with Wells Fargo and the Commonwealth Bank of Australia, used the technology to send a shipment of cotton from Texas to China. The parties involved in that deal tracked the shipment, which was made on a smart contract, from Texas to China in real time.
That was just the beginning. Trade finance on the blockchain could go beyond real-time visibility, transparency, and security. The next step is to turn these benefits into new opportunities for investment, even new financial instruments, narrowing the trade-finance gap rather than simply improve the sector’s current offerings.
There is a real chance that blockchain’s potential has been overhyped. In the case of trade finance, however, it might just be a tool that could make global markets more accessible at a moment when they seem to be closing off.
This article was originally published on ForeignAffairs.com.