This article was originally published on CTMfile: here.
Traditional banking trade finance products, like the letter of credit (“LC”), are much loved and trusted the world over. Supported by a network of internationally-agreed protocols (UCP600, URR523 and others) and the Swift 400 and 700 series of message types, documentary credits have become a staple feature of international trade.
But, as the annual ICC report shows each year, the percentage of global trade using documentary credits is declining each year.
On the other hand, whilst the role of the letter of credit may be coming to a natural end, banks will be able to re-engage with trade finance by funding the new breed of fintech platforms.
What do importers and exporters want from trade finance?
There are two tasks to be carried out, and they are quite simple:
- Get the exporter paid at shipment, the importer can pay later.
- A trade finance product should enable the exporter to get paid early and to shed the credit and payment risk of the importer.
- This is done by the provision of guarantees to pay in the future that can be discounted by the exporter, or simply by paying the exporter upfront.
- And the importer can take credit and pay the financier back later.
- Ensure that the exporter has done his job before he gets paid.
Before the importer assumes an obligation to pay he should have the reassurance that the exporter has done his job and supplied what is required. In trade finance, this is done via the provision and examination of documents that evidence the supply and shipment of the goods involved. See our trade finance map that puts these processes into context: here.
These are the outcomes desired. Traditional bank trade finance products deliver these results. Crucially, trade finance gets cash to exporters at shipment, and before delivery. This is different to invoice finance or standard supply chain finance – which typically deliver funds only after delivery.
The emerging alternative of the platform solution delivers the same results, typically supported by similar funders.
PrimaDollar provides such a platform, which removes the need for correspondent banks, and so removes a lot of cost and complexity from the process:
It is all about trust
The trade finance process set out above is dealing with the fact that the importer and the exporter are not in the same country. This leads to a lack of potential trust and concerns about what to do if things go wrong – as legal action in foreign countries can be challenging.
There are export-side risks, principally will the exporter supply the right goods? And there are import-side risks, principally will the importer pay?
Both parties always have the choice to trust each other – for example, the exporter ships and hopes the buyer will pay later, or the buyer pays upfront and hopes that the exporter has done his job faithfully – but this is not efficient. In fact, putting the import side risk (payment) onto the export side (supply) usually means it is mis-priced and funded at an inefficiently high rate.
That is the main purpose of trade finance products. They allow the import side and export side risks to be cut between the two sides of the trade at shipment. This is the efficient point to switch funding responsibilities. The export side funds the making period and gets repaid at shipment, the import side then takes over and funds the payment period.
Traditional bank trade finance is based around two banks acting as correspondents, each taking the risks that are local to themselves: the importer’s bank takes the importer risk, and the exporter’s bank takes the exporter risk. The banks, as regulated institutions, trust each other – and so this means that the importer and exporter are no longer directly exposed to each other’s risks.
Why are traditional products unpopular?
Around 90% of documentary credit business is carried out over SWIFT, so analysis of the volumes and values of SWIFT messages (700 series and 400 series message types) reveals the trends.
Extrapolation from the SWIFT data suggests the market share of traditional bank trade finance products has fallen well below 10% – perhaps from a high of 50% a few decades ago.
The alternative to using traditional trade finance products has been to trade on “open account” and often with the buyer deferring payment. This means that the exporter-side of the trade is funding and managing the buyer payment risk. As already mentioned, this adds costs to the supply chain because the importer risks are crossing over to the exporter side – and so the are being managed by the wrong side of the supply chain.
But this is changing. Supply chain trade finance platforms are now offering an alternative approach: all the simplicity and efficiency of a supply chain finance platform, but all the reach and scope of traditional bank trade finance products.
There are three main factors driving this trend, amongst others:
First, and perhaps most importantly, the world is becoming a much smaller place in terms of trust and information. With the internet, email and social media, it has become much easier to keep an eye on the performance of distant counterparties and even to assess their risks. This means that one financing party can coordinate both sides of the supply chain. There is no longer any need to have two.
Second, many supply chains have become well established. This has led to increasing trust between importer and exporter. This means that there is no longer any need to use banks to police the trades.
Third, we have the increasing popularity of supply chain finance programs. Many buyers have now taken control over how their supply chains are funded. The supply chain trade finance platform is simple evolutionary step – adding a trade finance dimension to an accepted invoice finance product. Significant cost savings can follow through standardisation and efficient financing of the supply chains over a platform.
What about blockchain platforms then?
Whilst traditional banking trading finance products are declining in popularity, the banking industry is fighting back. There are many blockchain platforms receiving large amounts of investment that seek to make the documentary credits work better (Komgo, Marco Polo, Contour to name a few). The use of blockchain in this context is fundamentally aimed at preserving the role of the LC and the correspondent bank approach.
So these new platforms are not moving away from the LC concept, and the coordination of correspondent banks. They simply take the existing product and put it onto a blockchain system. But this new approach does not fix the customer journey problem fundamentally inherent in the documentary credit product.
So, on the one hand, we have the banking industry focussed on its established products, investing in blockchain solutions to try and make their products work better – and on other hand, we have the fintech upstarts whose platforms can replicate the functionality of the traditional products but in a simpler and lower cost way.
Who is the client?
There is one very important difference between the new breed of bank blockchain trade finance platform and supply chain trade finance. Who is the client? The clients of the blockchain trade finance initiatives are typically the banks; the clients in a supply chain trade finance platform are the importers and exporters.
Which is the right strategy?
So there are two technology strategies to rescue trade finance:
- Put the existing trade finance products onto the blockchain
- Take a new platform-based approach using the principles of supply chain finance
This is not a race, and every approach will have its devotees. But, in our view, it is likely very clear which route is going to succeed. It takes 30+ steps for an exporter to monetise a typical documentary credit. Each of those steps is an interaction between two or more of the four parties involved (importer, importer bank, exporter, exporter bank). The number of steps and elapsed time are not materially changed by putting the process onto the blockchain, notwithstanding the claims of the new blockchain platforms. The fundamental issue is the customer journey and this has not been addressed.
The many steps are a result of the rule books that the banks use to determine what they will and will not do – UCP600 and its various brethren – and the large number of message interactions that are then needed to deliver results. The issue fundamentally lies in the correspondent model and the complexity of the relationship between the two banks. And of course, it is good to hear that rule books for some of the new blockchain bank platforms have now been developed – but surely trade finance without these rule books will be significantly easier for the customer?
On the new fintech platforms, the same result can be delivered in 6 steps.
Supply chain trade finance: the future
So, at the risk of being controversial, perhaps the future of trade finance should move away from the correspondent banking model? Perhaps there is a better way to deliver trade finance without LCs?
The new system, where importers and exporters deal directly with each other, is simpler, quicker and cheaper: connect the two principals in the trade via a technology platform that enables real-time and direct communication, supported by the integration of shipping documents and payments. Moreover, a better designed trade finance ecosystem using a much simpler approach will bring customers back to the industry – and will allow banks to recover market share in this sector.
And, it should be emphasised, this is not just a blockchain version of the legacy letter of credit – this is a new way to deliver trade finance into supply chains.
Supply chain trade finance – this is the version of trade finance that importers and exporters want. Moreover, once their customer journey has been simplified, trade finance will re-emerge as a major working capital product with wide adoption. And the banks, who fund these platforms, will recover their market share.
How can I find out more?
With a global network and global coverage, talk to us.
- Find out more about supply chain trade finance: here