Commercial Considerations for Using Blockchain in Trade Finance

A brief summary of Blockchains

Blockchains are shared, unchangeable electronic ledgers that facilitate the process of securely recording transactions and tracking assets in a network. Amongst other things, blockchains bundle digital records into blocks and these blocks are added to the end of a chain of blocks in chronological order. Blockchains are a form of distributed ledger technology.

The three main features of blockchain are:

• Exclusivity – It enables network participants to exclusively control ‘their’ records or cryptoassets;
• Chronology – It maintains a clear chronology of distributed ledger entries; and
• Consensus – It provides a mechanism by which network participants will reach a consensus as to new distributed ledger entries and the state of the distributed ledger from time to time, thereby ensuring a common, synchronised ledger. Without consensus, a new ledger cannot be approved, hence why blockchain is considered more secure than other digital mechanisms.

Public Blockchains vs Private Blockchains

Blockchains are being increasingly utilised, and it is likely that this will continue to increase in the future, given that they are more secure and can facilitate transactions at a quicker rate. For a business considering using a blockchain, one of the first considerations will be whether to use a public or private blockchain.

Broadly speaking, public blockchains, such as the ones used by Bitcoin and Ethereum, are permissionless, meaning anyone can be a participant. Private blockchains, on the other hand, are permissioned, meaning participants can only join through an authentic and verified invitation. A business should consider the following:

Public Blockchains

Pros:

• Because the blockchain is decentralised, participants do not have to trust an always-available central authority to manage it.
• Because participants can download a copy of the blockchain, send transactions for recording on the blockchain and view all entries in the blockchain, there is full transparency on the data held on the blockchain.

Cons:

• The lack of formal contracts in place makes it harder for participants to easily understand their rights and responsibilities and bring claims against entities they think have caused them to suffer loss.
• The consensus mechanism (see above) is time-consuming, costly to run and potentially detrimental to the environment (because of the computing power required for the blockchain to function).
• There is a lack of complete privacy and anonymity which may lead to weaker security of the network and participant’s identity.

Private Blockchains

Pros:

• There is one trusted intermediary in charge of running and managing the blockchain.
• This trusted intermediary decides what participants can send for recording on the blockchain and what data they can view.
• There are formal contracts in place governing the development of the blockchain and participation in it, such as:
  • A blockchain services contract between the blockchain developer and the trusted intermediary to licence its software and provide support.
  • A bilateral technology agreement between the trusted intermediary and each participant to govern the sending and recording of data on the blockchain.
  • A multilateral rulebook between the trusted intermediary and each participant and between each participant to focuses on the principles and processes that must be followed.

Cons:

• Participants must trust an always-available central authority.

Application of Blockchain to Trade Finance

It is expected that most commercial applications of blockchain, such as its application to trade finance, will utilise a private blockchain.

Looking at cross-border sales of goods arrangements, there are usually four key participants involved: the seller, the buyer, the seller’s bank and the buyer’s bank.

The usual issue arising from this arrangement is that the seller wants to sell the goods to the buyer but is concerned that the buyer takes receipt of the goods but then never pays for them. The buyer is concerned that if it pays for the goods before they are delivered then the seller may never deliver them.

The current workaround for this is using the letter of credit system which relies on a number of different documents (e.g. a sale of goods contract, bill of lading, letter of credit) being shared in different formats (e.g. by post, fax or e-mail). Here, a bank would issue a letter of credit on behalf of the buyer to the seller’s bank and, upon delivery of certain documents, the payment is then made. However, these documents are more susceptible to being lost, late or forged.

A private blockchain on the other hand can make the process more efficient and trustworthy.

• A trusted intermediary sets up a private blockchain.
• The buyer or buyer’s bank sends the digitised letter of credit for recording to the blockchain. This letter of credit refers to a smart contract which will implement certain obligations each party has relating to the letter of credit.
• The smart contract is created, approved and deployed to the blockchain. If the seller sends the digitised bill of lading to the blockchain and it is approved on or before the agreed date, then the smart contract automatically issues an instruction to the buyer’s bank to send payment to the seller’s bank. There is no requirement for anyone to do anything at that stage; the smart contract automatically executes the transaction.

There are a number of examples of blockchain being used in trade finance arrangements. Back in 2019, Chinese company Shenzhen MTC Co. used a private blockchain to complete a cross-border transaction with Hong Kong-based MTC Electronic Co.

HSBC Shenzhen branch issued a digitized letter of credit to MTC Electronic Co via the blockchain platform. HSBC Hong Kong branch then reviewed, verified and uploaded required trade documents (e.g. the bill of lading) to the blockchain. HSBC stated that the exchange of electronic documents was completed in 24 hours, compared to the typical 5 – 10 days for conventional document exchange.

In summary, we are expecting to see an increasing utilisation of blockchain technology by many businesses, not just large international corporations. The application of blockchain technology will not just be restricted to trade finance arrangements, but applicable across a wide number of different industries. If your business requires any assistance and/or advice then please contact a member of our Commercial Team by emailing info@leathesprior.co.uk or calling 01603 610911 who would be more than happy to assist.

Note: The content of this article is for general information only and does not constitute legal advice. Specific legal advice should be taken in any specific circumstance.