How blockchain-based facilities can close the $2 billion global trade finance gap

Estimated reading time: 5 minutes

Persistent structural gaps in and between the world’s economies will affect trade in the years to come. This was one of the key findings of the latest Future Of Trade report.

Change – and the reform processes that drive it – are challenging at the best of times, but they have been exacerbated by the protracted situation in Europe and the recent global banking crisis that has gripped the entire sector.

Despite these challenges, an uncontrollable gap exists in trade finance.

80% of world trade depends on financing, such as letters of credit and other short-term payment guarantees. This makes trade finance a crucial driver of economic growth.

The trade finance gap – the unmet demand for trade finance through rejected applications – was measured at $1.7 trillion in 2020 and is estimated to have passed $2 trillion today due to an increasingly hawkish attitude to risk and inflation eating into lending limits.

This gap particularly hinders small and medium-sized enterprises and emerging markets. SMEs tend to be the most credit-constrained, with estimates that half of SME trade finance requests are rejected, compared to just 7% for multinationals. About 68% of companies surveyed also said they did not seek alternatives after being rejected.

The macroeconomic and financial backdrop is such that the trade finance gap will increase in the short term. Despite this, there is significant potential for digital technology to help close the gap – either via streamlining onboarding processes for SMEs, or by opening up the sector to new sources of liquidity.

There are innovative platforms to meet this challenge. One such platform is DMCC Tradeflow, a digitized system to record the ownership of goods stored in UAE facilities, which was launched to address the crucial gap in the regional trade finance market.

It has witnessed a significant year-on-year increase in transactions over the past decade, which has fueled the platform’s expansion and capabilities. With record transactions achieved in 2022, Tradeflow is a great case study of the ongoing appetite and need for innovative trade finance solutions.

Building on this, an increasingly widespread technology that addresses these root causes directly is the blockchain.

Blockchain is by no means a silver bullet, and the term is thrown around so loosely that eyes often roll when it is brought up as a radical challenger to the global financial services system. However, the benefits of its real-world application in trade finance cannot be denied.

In terms of trade, blockchain makes goods traceable in real time, increases trust by guaranteeing the security of payments and financing, facilitates the verification of digital quality and origin certifications, enables the instant sharing of information at various stages of trade, and helps to improve how related public and private services work.

To date, blockchain has played a role in reducing the amount of paperwork that facilitates global trade. Most trade finance activities involve a significant amount of physical paperwork “hot potato” between the importer and exporter, their respective banks, shipping companies, receiving companies, local shippers, insurance companies and a variety of other parties.

Blockchain networks eliminate this series of inefficiencies by serving as a shared ledger that all parties can access at any time to receive the information they need to keep the trade finance process flowing seamlessly.

This is hugely beneficial in supporting the supply chain through reduced costs, error-free documentation and much faster transfer of documents between parties. By extension, this streamlines the introduction process for SMEs.

This application is well known; however, it falls short of blockchain’s true potential.

Log into the future: Smart contracts are the way to go

One of the more exciting areas for the widespread application of blockchain technologies in trade finance is smart contracts. This is where the real value comes from.

Smart contracts refer to a series of digital agreements that automate the execution of a contract from outside the chain. Because the actions are automated based on predefined terms and conditions, this enables the parties to cooperate, either much more efficiently through an intermediary such as a bank or without a hero.

In a typical trading scenario, this blockchain technology would allow digital agreements to be set up between two parties. The import and export banks would be able to review documents quickly and without the need for physical paperwork. The export bank will be able to approve the payment details and issue a smart contract to cover the terms and binding obligations.

The export bank will then be able to track the goods throughout the entire process as various parts of the smart contract’s conditions have been met. Finally, the contract would be fulfilled when the payment was made, again, automated through the blockchain.

This automation is expected to save between $15-20 billion annually. But aside from the savings generated, this will have an immeasurable impact on many underserved businesses affected by the $2 trillion trade finance gap by creating new, less constrained sources of liquidity that remain underpinned by trust and transparency.

As with any new technology, achieving critical mass will be critical to its adoption, but the benefits of operational simplification, reduced risk, automated compliance and faster settlement should be obvious to all. That said, the biggest potential benefit comes in the form of the vast untapped opportunities and markets that blockchain-based trade finance facilities would open up.

Progress is not linear: barriers to blockchain integration

There are of course barriers to overcome. Cost-effective scalability is the most prominent, and represents the main roadblock that blockchain’s application in trade finance has faced. But a fully functioning, scalable blockchain platform offers enormous potential and is increasingly feasible given the continuous iterative development of the technology.

Recognizing this, industry leaders such as various consortia of banks, including Contour and eTradeConnect, are driving the technology into reality, unlocking new opportunities for businesses and nations.

Ultimately, lack of trade finance due to lack of access and liquidity is a major impediment to trade growth and is a significant contributor to keeping poorer nations poor. The efficiency with which blockchain-based facilities can handle this cannot be underestimated.