Developing Digital Approaches to Trade Finance
By: James R. Holbein, Of Counsel, to Braumiller Law Group
The digital revolution affecting so much change across the world is coming to international trade processing and logistics. The transition to all digital documentation and processing from formerly inefficient analog systems is well underway. To comply with the World Trade Organization (WTO) Trade Facilitation Agreement, most countries have implemented “single window” customs processing of imports and exports electronically through a single electronic website, although the efforts vary widely as to filing requirements and means. Sensors allow tracking of goods and data collection from mine or farm to the ultimate sales outlet. Blockchain systems allow decentralized storage of information with high security and transparency. Machine learning and AI offer empowered analytical techniques for businesses to extract value and implement advanced strategy with their competitors. This article explores the transformation of trade finance enabled by the confluence of these new and evolving digital tools.
Introduction to Trade Finance
For companies engaged in international trade and commerce, trade finance provides the means for banks and other financial intermediaries to manage the risk of payments. Using trade finance facilitates transactions between importers, exporters, shippers, freight forwarders, customs brokers and other logistics providers to transact business through trade. Trade finance covers many financial products that banks and companies utilize to make trade transactions feasible. Various types of financial mechanisms and documents are covered under the term trade finance, including:
- Lending lines of credit from banks to help importers and exporters to manage payments.
- Letters of credit (LC) enable the buyer’s bank to guarantee payment to the seller for the goods covered by a contract. The buyer is protected because no payment will go to the seller unless the terms in the LC are met. Both parties must honor the agreement for the transaction to go through. Legal recourse is provided within the LC and the contract.
- Export credit or working capital is available to credit worthy exporters.
- Insurance should be used for shipping and the delivery of goods.
- Bank Guarantee: A bank acts as a guarantor for their credit worthy customers to mitigate the risk that one of the parties fails to fulfill the terms and conditions of the contract.
- Factoring is a very common method used by exporters to sell open invoices to a trade financier (the factor) at a discount. The factor profits on the difference between the importer paying the full price for the goods and the discount from the seller. Forfaiting is similar but is a form of export financing for medium and long-term receivables for capital goods by the forfaiter with repayment by the buyers of the goods.
Anti-Money Laundering (AML) regulations and laws also impact international trade transactions. Banks in the United States must comply with the Financial Crimes Enforcement Network (FinCEN), which was established under the Bank Secrecy Act (1970) in 1990. As a result, banks send Currency Transaction Reports to FinCEN for all transactions over $10,000, identifying the individuals and organizations involved. Other anti-money laundering statutes include the Money Laundering Control Act (1986), the Annunzio-Wylie Anti-Money Laundering Act (1992), The Money Laundering Suppression Act (1994), the USA Patriot Act (2001). Banks must “Know Your Customer” and require information filings to support these AML goals. These regulations can impede the ability of small and medium sized enterprises (SMEs) globally to participate actively in international trade, leading to smaller numbers of large enterprises handling the largest share of transactions.
Potential of Digitization to Streamline Trade Finance and Supply Chains
Innovation can help to open international trade to SMEs and expand the variety of goods available, as well as grow economies. New tools such as machine learning, artificial intelligence (AI), blockchain-based distributed-ledger systems, cloud-based computing, and digital identities can all help with operational efficiencies and secure records. Use of such globally available tools; along with the development of digital currencies, will help financial firms to operate seamlessly in nearly real-time across borders and in a variety of fiat and digital currencies, with fewer losses and improved efficiency. Among many advantages offered by digital currencies, they enable more secure collections and settlement for banks, essentially on a real-time basis, reducing the number of disputes and increasing efficiencies. Digital identities enabled by blockchain distributed ledgers can bring many of the disenfranchised SMEs globally into the global digital economy, without any loss of risk management for AML purposes. The physical handling of paperwork for traded goods is already an impediment to using single window electronic customs processing, so the transition to digital documents for financing of digital transactions is a natural progression that is being driven primarily by the private sector. The driver for these innovations includes advantages to commercial players and banks, such as disintermediation leading to lower costs and friction, machine learning providing data driven predictive analytics leading to sharper business decision making, blockchain records providing secure and verifiable proof of identity, and digital currencies speeding transaction time and reducing exchange rate issues.
Evolving Solutions and Players
Given the evolving situation, some of the current initiatives and organizations seeking to digitize trade finance documentation and processes are outlined below. This list is far from comprehensive, but gives some insight into the many initiatives underway to effectuate real change for financing international trade.
The International Chamber of Commerce (ICC) Banking Commission Executive Committee has updated its existing Uniform Rules for Collections (URC 522) and Uniform Customs and Practice for Documentary Credits (UCP 600) to include electronic means. It also approved a proposal to draft a new set of rules under the working title “Uniform Rules for Digital Trade (URDT)” in December 2018. The objective of the URDT is to develop a high-level framework outlining obligations, rules and standards for the digitalization of trade finance.
The United Nations Commission on International Trade Law (UNCITRAL) The UNCITRAL is formulating modern, fair, and harmonized rules on commercial transactions. UNCITRAL has a working group on electronic commerce and has promulgated a model law on electronic transferable records that will help guide legislation in countries as the Commission develops legal responses to the increasing digitization of trade documentation.
The International Trade and Forfaiting Association (ITFA): The IFTA established a FinTech Committee on January 1, 2018, that promotes the use of financial technology (FinTech) capabilities to transaction banks, insurance companies and capital market firms. The committee seeks to automate trade finance and establish trade finance receivables as an investible asset class, in order to expand the reach of trade finance resources globally. The group seeks to promote collaboration between regulated financial institutions and FinTech companies, provide platforms for new business eco-systems and practices, support infrastructure initiatives for new digital highways, and use transaction data to drive decision making. ITFA published a report on its Digital Negotiable Instruments Initiative this year, emphasizing the development of electronic Payments Undertakings (ePU) make negotiable instruments compatible with blockchain distributed ledger technology.
The Bankers Association for Foreign Trade (BAFT) The BAFT produced a white paper in July 2021 analyzing the progress on trade digitization. One of the key takeaways is that the technology strides are not being implemented as quickly as possible due to a variety of factors. Legislation and regulation in many countries are taking a variety of forms with little standardization. Commercial enterprises are slow to adopt new technologies and are waiting on the sidelines for the sector to settle into more accepted approaches. BAFT advocates somewhat bureaucratic approaches, including global trade associations supporting digitization through member action, ICC engagement with national and global groups to strengthen national digitization efforts, and pushing banks to use the available electronic rules to improve acceptance of electronic documents.
Central Bank Digital Currencies (CBDC): Governments are evaluating cryptocurrency regulations. Dozens of central banks are reviewing and running pilot programs to develop digital currency to issue, regulate and use digital forms of money. This effort is in response to the emergence of blockchain-based cryptocurrencies, including Bitcoin and Ethereum, as well as stablecoins; a new class of cryptocurrency issued by private companies that are pegged to fiat currencies in order to maintain a stable value and simplify payment systems using them. Note that Congress is considering legislation, the STABLE Act, to regulate stablecoins. Also, the Office of the Comptroller of the Currency published a letter on January 4, 2021, clarifying national banks’ and federal savings associations’ authority to participate in independent node verification networks (INVN) and use stablecoins to conduct payment activities and other bank-permissible functions. The agency letter concludes a national bank or federal savings association may validate, store, and record payments transactions by serving as a node on an INVN. Likewise, a bank may use INVNs and related stablecoins to carry out other permissible payment activities. In deploying these technologies, a bank must comply with applicable law and safe, sound, and fair banking practices.
Non-Fungible Tokens (NFTs): NFTs are a recent development in blockchain-enabled cryptocurrency that provides a cryptographically secure way of representing a unique asset. Once the asset is tokenized it creates cryptographically verifiable ownership of the asset and the asset cannot be modified. Not only are such tokens an exciting approach for managing intellectual property rights to assets, but they also present a possible way of tracking any good from creation to destruction.
Blockchain and Trade: “Blockchain has many potential financial applications. For example, blockchain is the technology underlying Bitcoin and other cryptocurrencies that can be used to make payments without banks or other third-party intermediaries. While cryptocurrencies potentially could create a more efficient payment system, they involve risks (there have been instances of compromised exchanges) and security concerns. Certain federal agencies have claimed regulatory authority over aspects of the cryptocurrency industry, but the patchwork regulatory regime involving multiple agencies at times creates regulatory ambiguity.”
Banks and other financial intermediaries pioneered the electronic transmission of funds through wire transfers, the SWIFT network, and other advances that responded to the market needs of their customers. The new technologies and initiatives described in the article are a continuation of that forward-looking perspective to gain efficiencies, reduce costs, speed transaction times, and reduce fraud and other criminal activity. There is no doubt that international trade is going fully digital, and the financial sector is obviously supporting that effort.
Below you will find the sources for much of the information in the article, as well as resources that provide insight into the topic in far more detail than this article can accommodate.
Blockchain & DLT in Trade: Where Do We Stand? White paper jointly produced by Deepesh Patel, Editorial Director, Trade Finance Global (TFG), and Emmanuelle Ganne, Senior Analyst at the World Trade Organization (WTO). November 2020.
Accelerating Trad Digitalization to Support MSME Financing, Deepesh Patel (TFG) and Emmanuelle Ganne, (WTO), sponsored by the ICC, TFG And WTO, March 2020.
International Trade and Finance: Overview and Key Issues for the 117th Congress, Congressional Research Service, February 3, 2021
Blockchain and International Trade, CRS In Focus, Congressional Research Service, 06/25/2019
Trade Finance, by Chris B Murphy, Reviewed by Brian Barnier, Updated Jul 23, 2020.
Federally Chartered Banks and Thrifts May Participate in Independent Node Verification Networks and Use Stablecoins for Payment Activities. Office of the Comptroller of the Currency News Release 2021-2 | January 4, 2021
The ITFA Digital Negotiable Instruments Initiative, Trade Finance Global White Paper, June 2021, https://www.tradefinanceglobal.com/posts/whitepaper-launch-bringing-negotiable-instruments-into-digital-world/
Guide to Trade Finance, ITFA and Trade Finance Global White Paper, 2020.
Trade Finance Guide, A Quick Reference for U.S. Exporters, U.S. Department of Commerce, International Trade Administration, Published November 2012.
A Primer on Smart Contracts, Commodities Futures Trading Commission and LabCFTC, November 27, 2018.
A CFTC Primer on Virtual Currencies, Commodities Futures Trading Commission and LabCFTC, October 17, 2017.
Blockchain’s Occam Problem, by Matt Higginson, Marie-Claude Nadeau, and Kausik Rajgopal, McKinsey on Payments, October 2018.
How to Bitcoin, by Kristian Kho, Khor Win Win, Crystaline Loo, Lee Shu Wei, Shaun Paul Lee, Teh Sze Jin, and Bobby Ong, CoinGecko, February 2021.
How to DeFi, by Darren Lau, Daryl Lau, Teh Sze Jin, Kristian Kho, Erina Azmi, TM Lee, and Bobby Ong, CoinGecko March 2020.
The author gratefully acknowledges the research and inspiration for this article provided by Justin Holbein.
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