The future of cryptocurrency and whether it can substitute traditional currencies is still uncertain; however substantial investments are made to exploit opportunities around bitcoin. As of today November 18th, Bitcoin is trading at its high above $750.
Bitcoin relies on Blockchain technology that comprises three main components: a network of computers, a network protocol and a consensus mechanism. The key point of the technology is that there is no central authority that ensures the validity of the transaction. In the traditional setting, clearing house would serve as a centralized ledger to clear the transaction, while blockchain relies on the entire network to approve the transaction. The system works as follows:
Blockchain technology is directly threatening clearing house and depositary institutions, which are important capital markets participants. However, blockchain has a potential to disrupt many other areas of financial services, one of which is supply chain finance. First, let’s overview how traditional supply chain finance work.
Supply Chain Finance
Supply chain contains multiple participants engaged in producing, purchasing, manufacturing and distributing products or services. The graph below shows simple representation of the supply chain:
At each level of the supply chain, participants need cash in different ways: suppliers need to pay for raw materials, manufacturers need to pay for inputs, etc. Rounds of negotiations take place among each parties to achieve better terms in order to reduce costs and manage working capital.
Banks are involved in these transactions as third-parties to remove the payment risk and the supply risk over the trade cycle, as well as provide financing when such needs arise across the entire supply chain. The process becomes more complex when the transactions are cross boarder and parties have to assume foreign counterparty risks. In such cases, multiple financial institutions are involved to distribute risks and make trade happen.
There are multiple financial instruments used in supply chain finance, some of the most popular ones are: letter of credit, standby, performance and advance payment guarantees, documentary collection, factoring (invoice financing), open account payment, supplier financing, etc. The differences lie in the distribution of risks and timing of the payments, as well as other terms of the agreement among participants. Letter of Credit is used for about 11% – 15% of trade transactions globally accounting for over a trillion US dollars volume per year. The mechanics of letter of credit is below:
As shown above, there are various forms of document presentations involved in the process. And the example above shows transaction between one buyer and one seller. How many documents exchange hands among multiple buyers and sellers across the entire supply chain? How can banks use blockchain technology to optimize the supply chain finance? Is blockchain threat or opportunity?
Standard Chartered Bank
Standard Chartered is a British multinational bank headquartered in London. The bank is actively involved in financing international trade and supply chain.
Standard Chartered has recently been involved in a large scale warehouse financing in metal industry, which resulted in huge losses. A warehouse company committed fraud and used the same stockpiles as a collateral in multiple banks to draw loans as part of the invoice financing transaction. As a result, Standard Chartered had to write-off $193 million to account for the loss.
Following the recent case, Standard Chartered has partnered with a bank in Singapore to develop blockchain-based trade finance platform. With the new platform, parties will rely on open source, consensus based protocol to executive trade finance transactions.
Is this a solution?
Supply chain financing is a documentary business. According to the Trade Finance Analytics, the financier needs the following tools for the effective execution:
- control of the use of funds, goods and sources of repayments
- visibility to monitor the transaction
- security over goods and receivables
Blockchain technology provides opportunity to address all the above challenges, therefore new platform seems to be a good solution to avoid similar losses incurred earlier by Standard Chartered.
The question remains: if all transactions are recorded on a public ledger, will this cannibalize some of the businesses banks currently do? Why can’t corporates set up its own blockchain platform in future and execute certain transactions without banks’ engagement?
Is blockchain threat or opportunity for the banks?