Global trade still relies on slips of paper, not far different from the stone tablets used in Ancient Babylon, but the coronavirus pandemic could encourage the adoption of blockchain technology to digitize the archaic business.
In Shakespeare’s The Merchant of Venice, Antonio a merchant, takes out a loan from the moneylender Shylock to fund a trading mission, but instead of property as surety, Shylock, asks for a pound of flesh should Antonio be unable to pay.
And while flesh was rarely used as surety in 16th century trade finance, for all practical purposes, it might as well have been.
The treacherous trade voyages that set off from European seafaring nations, with ships sailing across the globe in search of treasure, were extremely profitable, but risky propositions.
And financing those voyages was often a gamble that was shared between wealthy merchants, so that the failure of any single voyage wouldn’t be enough to ruin a family’s fortune.
But given that one successful voyage was able to pay for another three, there was no shortage of merchants willing to take on the risk of funding these adventures, and no shortage of moneylenders willing to lend them the money to do so.
As the Christian laws against usury (lending with interest) prohibited Christians from lending money to one another, many merchants of the day turned to Jews, who also had the same laws against lending to one another, but conveniently had no laws prohibiting them to lend to Christians.
But given that most of those merchant loans were taken to fund extremely risky voyages, exposed to the elements and pirates, moneylenders such as Shakespeare’s Shylock had little choice other than to demand their pound of flesh for surety.
And while today’s trade financiers may no longer demand their pound of flesh, they might as well be.
A Pound of Flesh
Trading with faceless counterparties across vast expanses of ocean today is somewhat less risky than it was during Shakespeare’s time in that navigation, shipping and technology have all improved, but there are still pirates, weather and insolvencies to contend with.
Manufacturers may not get paid on their invoices, goods delivered may not be up to the specification as they were ordered and anything could happen in between the time goods are produced to the time they are delivered.
And because there is a constant tussle between buyers who want the goods as soon as possible and sellers who want to be paid as soon as possible, intermediaries, modern-day Shylocks have stepped in to fill that gap.
Trade financing until very recently, has been a relatively staid business.
The vast majority of transactions are completed with minimal hiccups.
But the coronavirus has upended the entire trade finance business and hastened the push towards digitization.
This year, trade credit insurers, insurers who provide protection to sellers should an invoice go bad, have slashed the amounts that they are willing to cover from as little as 50% to as much as 90%.
And that’s meant that the Antonios of the world have either had to shoulder the risk of an invoice going sour themselves, or simply not dispatch the voyage.
The problem is not small.
It’s estimated that around 20% of global GDP is owed between firms in the form of trade receivables — as yet unpaid invoices.
Some firms bear the risk of non-payment on their own books, but many others look to insurers to protect them from default, or resort to Shylocks and take out specialist loans, backed by the invoices.
Trade finance collectively underpins 80% of all cross-border transactions, which are worth an estimated US$15 trillion a year.
Coronavirus Comes For Cross-border Trade
But the coronavirus pandemic has thrown a spanner into the typically predictable business of trade finance in several ways.
Trade finance is still very much a paper-based business, something that hasn’t changed much since the time of Shakespeare.
From financiers to logistics providers, warehouse managers to customs officers, an average of 36 documents and 240 copies will need to be exchanged in the course of a single transaction.
Letters of credit, bills of lading, invoices and a whole bunch of standard paper-based contracts would typically crisscross the world in the cargo holds of passenger aircraft.
But passenger aircraft grounded by the coronavirus has meant that millions of these documents have had to find alternative means to travel.
And even when the documents did make it across oceans, couriers got to banks only to find no one manning the offices because of lockdowns.
Overnight, counterparties had to start getting “creative” — banks started accepting, believe it or not, scanned signatures and documents (gasp!).
And cargo firms started issuing four times as many electronic bills of lading — receipts detailing goods onboard a ship — in March, as they did in February.
And while the shift to electronic documentation has helped curb some delays, there is worry in the industry that electronic versions of documents could give rise to more fraud.
In that respect, the blockchain may proffer an obvious solution.
Banking On Blockchain
Because there are so many copies of so many different documents, but no universal oracle of the veracity of those documents, physical copies (much like cash) was the way trade finance dealt with the potential for fraud.
Cash is pretty straightforward, it’s either there or it isn’t.
But even cash can be counterfeit and as those in the trade finance industry will profess, so can the documents making up any transaction.
Faked invoices and bills of lading, while not common, are still known to be an issue in some more dodgy corners of global cross-border trade.
Which is why a blockchain solution would be dramatically more streamlined.
Sellers could upload encrypted documents to a public or privately-maintained blockchain that can only be accessed by the intermediaries facilitating the transaction and that one set of documents, which can be inspected by all concerned parties becomes the single source of truth.
A single and independently verifiable source of truth would help to reduce the sheer amount of paper that needs to travel across vast distances for what in some cases, may be relatively minor or standard transactions.
And blockchain technology could also help with the issue of non-payment on invoices.
The sudden disappearance of revenue because of the coronavirus has meant that the risk of existing loans going sour has increased dramatically, making lenders more cautious about making new loans or providing credit on invoices, which are at greater risk than ever or not being paid.
Trade finance has long been seen as super safe — annual default rates on letters of credit averaged 0.11% of transactions in the decade between 2008 to 2018, with less than a tenth of that for corporate loans.
But trade finance insurers have already reported payment delays and while there hasn’t been a wave of bankruptcies, thanks to generous levels of central bank intervention, a rise in bankruptcies could make matters worse.
Some trade-credit insurers already expect defaults to rise by a third globally by 2021.
But trade finance is typically short-term — between 30 to 90 days, and backed by collateral, which means that creditors are not exactly left feckless should things go bad.
Again, this is something that blockchain could potentially solve.
Using smart contracts, whether based off the Ethereum blockchain or other smart contract-enabled blockchains, the potential for nonpayment becomes dramatically reduced.
Because a typical cross-border transaction involves several parties, it’s entirely possible for a programmable smart contract, tied to existing deposits of a digital currency or digital wallet, to enable automatic payments upon successful receipt of goods, with independent oracles verifying such receipt and therefore enabling the transaction to pass.
There could be multi-signature smart contracts where the acquiescence of more than one party is required to release the funds in escrow to the supplier, which would significantly reduce the time needed from the receipt of goods, to the provision of payment.
And even when credit terms are provided, at the end of those terms, suppliers wouldn’t be left wondering if payment would ultimately be made, because the smart contracts could automatically execute the transfer.
But where the bigger gap lies is in the procurement of new sources of trade financing, which have plummeted as firms’ cashflows have dwindled.
The credit rating of firms are downgraded quickly, but upgraded slowly and some lenders may focus on large clients or exit some markets entirely.
In emerging economies, sovereign downgrades have posed a drag on corporate ratings and insurers have already cut their exposure to the trade finance industry as a whole by as much as 9%, or approximately half the amount of cuts during the 2008 financial crisis.
To be sure, the damage could have been far worse.
Since the 2008 financial crisis, banks have beefed up their balance sheets and during the early days of the coronavirus pandemic, policymakers wasted no time to pledge support for their economies.
Central bank intervention has helped shore up lenders’ battered finances and governments have let export credit agencies cover short term trade, offering insurers backstops.
But no one knows how long the support will last and it could potentially disappear just as the demand for trade finance returns.
With many economies already re-opening or re-opened, new orders are working their way through supply chains, and exports appear to be leading manufacturing.
If trade finance freezes up, this nascent recovery could easily seize up as well.
In a market where the creditworthiness of everyone is in question, the blockchain can again act as an independent and independently verifiable arbiter of creditworthiness.
Buyers will need to put up before they order up.
But perhaps there is a silver lining for trade finance as the coronavirus pandemic has forced an archaic industry to digitize.
Some 60 chambers of commerce have opted for electronic certificates of origin in recent months, up from the usual rate of 10 a year, and some countries have already adopted laws to recognize the validity of digital documents.
Digital standards could make it easier to bundle trade finance loans into securities that could then be sold to institutional investors, breathing life into global commerce by co-opting new pools of liquidity, and all independently verified by the blockchain.
Trade finance hasn’t changed much since the time of Shakespeare and just because Shylock demands his pound of flesh, shouldn’t mean that he is entitled to a drop of blood.
Coronavirus Hastens Trade Finance’s Blockchain Moment was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.
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