Updated: Aug 24, 2021
When it comes to technology, there isn’t an industry in the world that hasn’t been fundamentally affected by the emergence of the digital revolution. Since its inception decades past, it has moved at break-neck speed. Trade finance it seems, has lagged behind the new wave, and is waiting for its own transformation. Is it coming any time soon?
The World Trade Organization estimates that somewhere between 80-90% of global commerce is reliant on trade finance, and that this type of business tends to be short-term. Trade finance is also typically quite complex, and each transaction requires the input of a number of people in different locations across the world. National boundaries then, can become barriers to safe and trustworthy trade. Without monetary assurances from the trade finance community and the connectivity that comes with it, entities in less developed parts of the world are constrained and remain provincial. Needless to say, lost business opportunities are the predictable result, and these limited enterprises are made more vulnerable. It is worthy of note too, that trade finance instruments as investable assets are becoming more attractive, and what with the reduced business opportunities that come with lack of trade finance availability in developing economies, it could be argued that missed business opportunities are potentially magnified.
A seemingly innocuous word but the bane of the trade finance sector is paper. Compared to the leaps and bounds being made through digital advancements in other areas, the trade finance ecosystem relies heavily upon it. Currently, the framework provided through trade financing to the export/import arena globally, requires the documentation of millions of transactions year on year. As the world has shrunk and trade has flourished, this way of doing business has become increasingly old hat. And consider too, how such a system makes financial crime possible. Paper is easy to forge, lose, or destroy. An obsolete system such as this requires constant scrutiny, an endless impositio on the compliance industry.
A Gulf not a Gap
It is starkly apparent to anyone doing a cursory search on the internet that there exists a trade finance gap. Exactly how big that gap is depends on where one looks and how old the source is. In 2019, the Asian Development Bank estimated the gap to be $1.5 trillion. Standard Chartered calculated the gap to be somewhere in the region of $3.4 trillion in August 2020, perhaps not a total surprise what with the infamous arrival of COVID-19. Regardless of the various estimates being made about the trade gap out there, what seems to be fairly evident is the fact that it is large and is likely to get larger.
The trade finance gap is a huge fly in the ointment of the industry. It may be somewhat reductive to simplify, but it is essentially the difference between the amount of finance requested by all entities around the globe attempting to sell their wares or services, versus the amount of financing banks and associated entities are willing or able to provide. The gap itself is not born of a disinclination by banks to provide financing. In reality, it is an inability to cope with the increasing demand for finance, restrictions imposed by compliance, dubious credit quality, and the demands of regulation.
Speed Bumps on the Road to Transformation
However one may view the trade finance gap – whether it is a ‘natural’ phenomenon within the industry, or a failure of the system – it is evident that it is a significant impediment to the progress of the sector. According to the WTO, the biggest hurdles for banks in supplying trade finance is regulation around AML and KYC, Basel compliance, and mediocre credit ratings of issuing banks and countries. These are in conjunction with what might be regarded as the traditional reasons for trade finance deficiencies – perceived high risk, regulation paucity, low demand, and low profit – of infant economies. Indeed, further to this still, issues such as the finite scope of local markets to provide financial instruments, and the even failure of banks to create global correspondent communication.
Away from the Old World
Trade finance is in the process of digitization. It is also going through another change – which may or may not be a result of that digitization – disintermediation. Essentially, this is the gradual removal of intermediaries between entities, such as between producers and consumers. Such technological integration is occurring so that financial organizations can reduce costs and reclaim lost profits from cyclical financial crises. One of the most conspicuous examples is how businesses are moving online, something made critical by the advent of the global pandemic. With time, trade finance will surely see a fundamental shift away from the archaic paper processing of the old world.
Figure 1: Conceptualization of the digitalization of business.
The internet knows no boundaries and as smaller and smaller businesses rise to meet the new media, so their horizons will be forever broadened. Fintechs are able to exploit the new advances since they are then able to find new and innovative ways to finance trans-border trade. Equally, their new platforms are inventing ways and means to spread risk across multiple entities, which consequently can have the effect of diluting banks’ antipathy for risk. Online business too normally means automation of business, which reduces complexity and increases connectivity across the world. In particular, the creation of the ‘web portal’ has enabled financial entities to simplify the protection of transactions and make provision for credit.
A realization occurring within banks and financial entities too, is where the originate-to-distribute business model might be put to use in the trade finance ecosystem. Having seen prolific use in the global housing market, financial instruments as well as trading books are being reimagined as assets and allowing for the creation of new ways to fund cross-border trade. A cascade effect can then occur, where all parties in the trade finance ecosystem benefit: the financing entity can expand on their Net Interest Income, as well as their Return on Equity, and will widely be able to achieve more with less.
The natural next step for trade finance is to create a technological solution that unifies all portals and all platforms everywhere, across the entirety of the trade finance ecosystem. A tall order perhaps. But there is technology emerging that can create transparency and be owned by all: blockchain. The reason why blockchain technology piques keen interest is its capacity to give ownership of the whole system to everyone who takes part. This has come to be known as decentralization. Using it to great effect in the digital universe today are bona fide cryptocurrencies, of which, the eminent Bitcoin stands out.
High level encryption allows all parties to hold a ledger of ownership, a ledger that gets updated with every transaction. The ledger allows for transparency, tighter security, and the promise of the complete elimination of paper. Blockchain could permit financial entities to track transactions from end-to-end, and all involved parties would be able to remain concurrent with latest developments. Other positives would be the collectivization and compartmentation of data, the immediacy of counter measures in light of attempts at criminal activity like fraud, and the digitization and digitalization of documentation.