There are challenges as trade-based loans have higher documentary requirements, are operationally intensive and require additional cost to adhere to regulatory and compliance policies.
Trade finance has been of key importance in the ever-changing economic and political landscape of global economies, and it is going through a paradigm shift.
The shift is incidentally predictable as banks are now part of a technology curve, which is steeper and desirable. Steeper as new age technologies like Blockchain, IoT, Big data, AI, Machine learning etc. is changing the way we do banking and changing faster than we can imagine.
Desirable as Indian banks have been cautiously conservative and looking at ways and measures to identify and mitigate risks arising from their large global operations.
Trade finance holds significance for both banks and the companies. Indian companies are using trade finance for better balance sheet management helping improve their leverage and financial ratios.
Banks helps in faster debtor realisations for the seller and mitigate risks associated with the buyer in terms of default risk, country risk, forex risk, legal and regulatory risks. Banks further support in extending cheaper liquidity as the risk is predicated on a better-rated counterparty or bank.
Banks, on the other hand, prefer trade based loans as part of their asset book for being short-term, self-liquidating and allowing them to verify the underlying trade documents.
However, there are challenges as trade-based loans have higher documentary requirements, are operationally intensive and require additional cost to adhere to regulatory and compliance policies.
For example, the most prevalent form of bank-intermediated trade finance especially in emerging economies i.e Letter of Credit (LC) has its own challenges.
LC requires presentation of physical documents including full set of Bill of Lading (B/L), documents have to flow physically from counterparties to banks and there is lack of insight of flow of goods and documents. UCP-600 (Uniform Customs and Practice for Documentary Credits), the governing rules for issuance of LC, requires banks to determine documents on their face to be credit complying presentation.
Banks, however, are going beyond and cross-verifying various aspects in the LC documents to mitigate any possible fraud risk, double financing risk, and accommodation risk. Moreover, these factors have limited the growth of trade finance markets as large set of micro, small and medium enterprises remain unbanked.
Technological developments are trying to address these issues and Blockchain seems to be the most promising among them. The blockchain is decentralised and distributed ledger technology (DLT).
With DLT trust comes from the transaction process which is more secure and robust than the traditional models used in trade finance. Taking the analogy of LC-based transactions, all participants in the LC will have their own copies of data, where changes get validated by participants collectively and updated across the system. Therefore there is one and only one version of truth which is unalterable and accurate.
Refer Exhibit 1, in the traditional LC process, supplier approaches each participant’s separately in order to fulfill the requirements under the LC in a serial order. Traditional LC’s can take as much as 30 days for the supplier to be able to finance and liquidate their bills. In comparison, LC transaction in Blockchain will be faster as all participants will be involved on real time basis reducing the time for the presentation of documents. Refer Exhibit 2
The blockchain ecosystem will streamline the process of document presentation and financing, mitigate fraud risks as banks can see and verify documents presented by each participant and as a consequence will revolutionise trade finance.
Moreover, the time for presentation and financing of bills can be significantly reduced leading to higher liquidity and billions of dollars in savings. As per the exhibit has shown above, one can predict time for the presentation of documents getting reduced by a third.
Insight of the transaction along with secure and reliable architecture can lead to higher penetration to the unbanked sector leading to further financial inclusion.
Institute of Development and Research in Banking Technology (IDBRT), established by Reserve Bank of India (RBI), has published a whitepaper which provides a roadmap for the applicability of Blockchain in the financial sector and provides the necessary impetus required in accelerating the adoption of the technology in India.
Large Indian banks have been experimenting Blockchain solutions under collaborative strategies which can help achieve scalability under secured close loop architecture. ‘Finacle Trade Connect’ is a collaboration involving banks and Edgeverve, an arm of Infosys.
The solution is designed to help digitise trade finance process including validation of ownership, certification of documents and making payments while working on a distributed, trusted and shared network. Currently proposed partnership will mitigate challenges of platform applicability, scalability and interoperability with availability to manage B2B, C2C and B2C based transactions.
The technology requires to be applied for production which will provide clarity with respect to the actual cost incurred, speed for executing the transactions, storage requirements etc. While a strong governance framework can address the concerns related to intellectual property and data protection, a robust regulatory framework will further help the technology thrive.
As stated in the ICC Banking Commission Report 2017: “It has become clear that FinTech, and the digitisation of trade based finance are no longer just phrases or buzzwords.” It’s time to move beyond successful PoC (Proof of Concept) to actual production and for the Blockchain technology to live up its potential. While it may not be a utopia to start with, it will address some of the concerns and challenges currently faced in Trade finance.Disclaimer: The author is Sr. EVP & Business Head – Global Transaction Banking & Precious Metals at Kotak Mahindra Bank Limited. The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.