The Role of Blockchain in Transforming Digital Trade Finance

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The Role of Blockchain in Transforming Digital Trade Finance

Digital Trade Finance is an umbrella term that represents borderless trade facilitated by a network of commercial partnerships in this globalized worl

Digital Trade Finance is an umbrella term that represents borderless trade facilitated by a network of commercial partnerships in this globalized world. It includes an array of financial products and instruments that help facilitate cross-border transactions between commercial partners. Its role also includes risk reduction, reconciliation of diverse exporter and importer terms, and upholding the laws determined by authorities.

As trade finance is a complex institution, it traditionally has been reactive, slow, and problematic yet necessary for market participants. Current trade market finance has already exceeded $46 billion in volume which is expected to grow with a steady CAGR of 4.5%. This figure represents a value without factoring in developments such as the inclusion of blockchain technology. 

As blockchain technology is solely integrating with the conservative international business sector, the industry will witness a boost in growth in the coming years.

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Experts predict that with the inclusion of modernization and digital finance, the trade finance industry can grow to become a $68+ billion market by 2032.

In this article, we will take a look at how blockchain can boost development and security in trade finance while observing a few challenges, opportunities, and trends.

What is Trade Finance?

Before understanding the inclusion of blockchain in digital trade finance, we first must understand the meaning of trade finance. Trade finance consists of complex methods, instruments, and mechanisms to enable foreign trade transactions by leveraging credit resources from international credit and financial markets by domestic banks.

Centralized banks play a vital role in facilitating such resources, but they are not the only financers. Funds can also be provided by a third party, such as an export agency, international trading companies, or specialized non-bank financial institutions. Let’s dive deeper and understand how trade finance works.

How does Trade Finance Work?

In simpler terms, trade finance refers to a process of granting financial guarantees in exchange for the completion of the transfer of goods or services. As any party involved with an international trade deal would not want to fulfill their obligations without having tangible guarantees from the counterparty, the importer’s bank can issue a letter of credit to cover the exporter’s cost for transferring the goods. 

This letter of credit acts as a financial obligation for the importer to pay out the outstanding sum after receiving the shipments. Upon receiving the shipment, the important must sign the bill of lading for the actual arrival of the products.

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Once these documents are signed and submitted to the letter of credit issuer, the importer must pay the entire sum to the exporter, in exchange for access to the goods.

In this scenario, the third-party bank acts as the intermediary to ensure trustful transactions. There are two types of banks involved – the remitting bank for the seller, and the collection bank for the buyer.

The Role of Blockchain in Trade Finance

Now that we know more about how trade finance works, the next step is to understand what role blockchain plays in trade finance. As one can imagine, trade finance has been around for decades since the beginning of globalization as no seller or buyer would want to put advance payment or resources without any guarantee. Additionally, it helps to foster international trade deals and helps boost the global economy.

However, the conventional trade finance processes are not just slow, but also very complex and bureaucratic. According to the rules of the International Chamber of Commerce (ICC’s publications UCP 600, ISP 98, and URDG 758), all trade transactions must be hosted on the SWIFT platform and require to go through multiple banks semi-manually, which makes the entire process time-consuming and costly. Moreover, this process lacks transparency and does not give a clear idea of the final incoming sum of payment.

These evident shortcomings have hindered the growth of the trade finance industry and prompted it to seek better solutions with the same level of trade deal security and without the SWIFT-related overheads and red tape.

The solution became evident as blockchain technology gained the spotlight with its unparalleled security, transparency, and the power of removing intermediaries.

Blockchain is a digital ledger where data is stored about the ownership of an asset or any transaction details. Blockchain makes it possible to carry out currency transfers and facilitate the process of delivering products to customers.

Blockchain helps companies manage their assets, determine the best method to carry out activities, and also offer secure ways of identity authentication.

While these benefits of blockchain can help trade finance tremendously, the biggest benefit lies in the use of smart contracts, which offer a new and progressive approach to trade finance agreements. Migration of trade finance to blockchain technology will unlock an array of new benefits, including:

  • A faster way to facilitate trades using automation and self-executing smart contracts.
  • Removing intermediaries and ensuring faster transaction processing by using a p2p model instead of multiple financial intermediaries.
  • Replace the time-consuming invoice factoring with quicker and zero-risk smart contracts.
  • Enhancing identity authentication using KYC/AML procedures with counterparty verification and authentication.
  • Simplifying communication by hosting all documents and trading deals on the secure blockchain network.
  • Avoiding document duplication and bureaucracy using single document storage and an effective validation process.

These are the few ways in which blockchain can optimize the trade finance industry. Counterparties can operate with great efficiency in their dealings and preserve real-time access to all the documents, shipment tracking information, and communication data.

Blockchain helps to simplify auditing processes and enhances the security of the whole trade deal, where as a result, trade partners can achieve greater autonomy without having to refer to correspondent banks and pay considerable fees for trade finance oversight.

One of the best examples of the use of blockchain technology in trade finance is presented by Silk Road Coin, a blockchain project and utility token that is powering import and export between Eastern and Western economies.

It is one of the first real-world business use cases of crypto tokens that brings the real economy of global trade to the crypto market. To achieve this, Silk Road Coin uses its own digital commodity trade finance and global supply chain ecosystem.

Benefits of Blockchain

By now we know more about how blockchain can be integrated with the trade finance industry and which areas it can optimize. Let’s summarize the benefits of blockchain technology in trade finance.

  • Reducing the cost of transactions.
  • Ensuring security and trust between participants.
  • Increasing the speed of data exchange and mitigating fraud and risk.
  • Ensuring immutability and finality of trade deal transactions.
  • Promoting transparency in operation and ensuring universal access to the content. 
  • Low to zero commissions and removal of intermediaries.
  • Improving reliability and ease of conducting transactions.

While there are several benefits and advantages of incorporating blockchain in trade finance, there are a few challenges that can hinder a seamless integration. These challenges include:

  • A learning curve to understand and master the intricacies of smart contract generation and arranging trade finance deals on blockchain.
  • Unclear regulations and compliances.
  • There is a lack of standardization and interoperability between different blockchain networks.
  • Cybersecurity threats and hacks.
  • Privacy concerns when sharing sensitive trade deal information.
  • Institutional resistance to the adoption of blockchain by centralized banking institutions.

While these challenges can be mitigated with a more responsible approach to integrating trade finance with blockchain technology, the biggest problem lies on a psychological level.

Blockchain technology is thought to be harmonious with cryptocurrencies, which has caused an array of concerns for its high volatility and scam products. However, cryptocurrencies are one of the products born out of blockchain technology and blockchain exists independently of cryptocurrencies.

The impact of blockchain technology lies majorly in its three important components, which include – efficiency, legitimacy, and digital identity.

These three aspects of blockchain technology can be integrated with a variety of sectors and presently various banks are starting to experiment with implementing this technology at an institutional level.

This proves that blockchain technology is potentially a game-changer for the entire digital landscape and can be a game-changer for the trade finance industry.

How can Trade Finance work using Blockchain?

Blockchain technology initially became popular due to cryptocurrency. However, it is an advanced technology with cryptocurrencies as a mere use case and not the sole purpose of the technology.

It is a distributed ledger that can store information that can include transaction details, ownership details, certification, and so on. All the information stored on a blockchain network is also visible to all participants in the process and cannot be modified or tampered with. These properties of blockchain can help remove intermediaries from the trade finance industry, effectively reducing costs and fraud. 

Blockchain technology has undoubtedly pioneered the use of blockchain technology as a decentralized financial system that interests everyone dealing with the bureaucracy and limitations of centralized finance institutions.

Cross-border payments using blockchain-based money can be done instantly, while using traditional mediums such as SWIFT can take up to three business days. Moreover, blockchain can be used for both customer verification and reporting to regulators.

While blockchain can optimize day-to-day transactions, its true potential lies in optimizing an enterprise with several suppliers, buyers, and franchises, with the need for constant monitoring.

For example, in the logistics industry, blockchain can help in sharing documents and simplify the lengthy and tedious process of verifying details.

Another important use case born out of blockchain technology is smart contracts. Smart contracts are self-executing contracts that can automate several processes in the trade finance industry.

Smart Contracts in Trade Finance

Smart contracts are a revolutionary addition to the blockchain network and operate using logic. When the predetermined conditions are met, the smart contract can be programmed to execute itself.

For instance, in a game of dice, the gaming platform can execute a smart contract to release rewards to the player’s account if he rolls a pair of sixes. Only if the player rolls two sixes simultaneously, the smart contract will be activated. The automation capabilities of smart contracts can be utilized in the trade finance industry, with key benefits, such as:

  • Ensuring transparency of transaction’s real-time status.
  • Improving the speed of shipping initiation and ensuring a shorter trade cycle.
  • Allowing for real-time review of the trade finance process by regulators.
  • Facilitating transactions between untrusted parties without needing third-party oversight.

These advantages in the trade finance industry are possible because of the smart contract’s self-executing nature. Like classic contracts based on mutual agreement on set terms, smart contracts also require both parties to fulfill their part to close the deal.

These contracts are pieces of blockchain code programmed with terms using code logic and can only be executed when there is substantial proof of both parties fulfilling their contractual conditions.

The USP of smart contracts lies in their immutability which is achieved via decentralization. Smart contracts can only exist on a blockchain network and are stored on multiple devices of the chain’s nodes, making it impossible to manipulate their conditions or commit fraud.

Other added advantages of smart contracts include storing all transaction data in a public ledger to simplify audits and streamline KYC/AML procedures for international trade operations.

Trends and Opportunities in Blockchain Trade Finance

As the global trade finance industry makes significant strides towards blockchain integration, there are noteworthy trends and opportunities to monitor in 2024.

Addressing Blockchain Fragmentation

The blockchain landscape is diverse, featuring numerous non-compatible platforms and networks. This lack of uniformity poses a potential challenge to global blockchain adoption in trade finance.

A crucial trend on the horizon involves consolidating blockchain technologies and enhancing interoperability. This ensures that participants can engage in transactions seamlessly, eliminating risks and friction.

Institutional Engagement

While institutional players such as banks and global financial organizations actively explore blockchain, its widespread adoption remains uncertain.

The future integration of blockchain into trade finance operations hinges on the pace and scale of acceptance by financial institutions.

Streamlining Documentation with Automation

While it’s not a cure-all for the challenges in the trade finance industry, blockchain holds significant potential for digitizing documentation. This shift minimizes manual labor, reduces document duplication, and streamlines the trade finance process.

Such automation promises increased speed and efficiency, even in scenarios where blockchain is partially implemented in trade finance.

Conclusion

Blockchain epitomizes decentralization, transferring control over data to users who can manage it independently. IT leaders should strategically rethink their blockchain approach, anticipating a growing user base unwilling to relinquish control of their data.

This article explores how blockchain technology can revolutionize the trade finance sector. While acknowledging that blockchain isn’t flawless, it represents a substantial improvement over legacy systems. A well-executed trade finance blockchain holds the promise of enhancing international trading experiences.

Despite the imperfections and the need for cautious implementation, blockchain signifies a positive step forward in achieving improved speed, efficiency, and transparency in trade finance.

Forward-thinking businesses involved in or contemplating entry into trade finance through innovative blockchain solutions can consider 4IRE as a reliable development partner.

With a team of over 300 qualified blockchain specialists, we can create a cutting-edge trade finance platform aligned with your technical requirements and business vision. Reach out to us today to kickstart the implementation of your promising business idea with substantial market potential.

Disclaimer: This is a sponsored guest post and should not be taken as financial advice. Please do your research before taking any action regarding any entity mentioned in the article.

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