Whether referencing green coffee or crude oil, the vast majority of commodities must be transported from a producing region to an area of consumption. Throughout a commodity supply chain, the ownership and control of goods, which are not always the same, will pass through dozens of hands. This presents capital providers with a complex and ever-changing collateral package. Yet in today’s digital age, a bank’s ability to track title still remains mired in paperwork and cumbersome documentation. This article explores the opportunity for blockchains and distributed ledgers to become a new digital backbone in the commodity supply chain and trade finance industries.
From producer to freight forwarder, warehouseman, processor, exporter, shipping company, customs inspector, importer, reprocessor and distributor, the shifting location, title and control of physical commodities presents stakeholders with a challenging volume of paperwork and legal complexity. The web of paperwork leaves the doors open for collateral manipulation or value misstatement on the part of a distressed company. The wherewithal of such a company to defraud its bank lender could be significantly hampered by the adoption of blockchain technology. Yet despite the risks posed by relying on physical documents and the availability of emergent technology to address these risks, trade finance banks have been slow to embrace it and still depend either on paper collateral or more simply on a “borrowing base report” in which a borrower provides lenders with a list of their collateral. Trust replaces paper in this type of standard working capital financing arrangement. The large majority of readers will agree that the foundation of most relationships – and particularly in the commodity industry – is trust. Within the realms of commodity finance, it can be tempting for a troubled company to “patch things up” by inflating the collateral position that is self-reported to banks. Banks trust their borrowers; when that trust is broken, its damage on the relationship is usually swift – and irreparable.
Blockchain, the technology best known for underpinning the digital currency Bitcoin, may present a solution to capital providers to dramatically improve efficiency while reducing risk and operating costs. The cloud-based peer-to-peer database technology could reduce paperwork and transactional costs, remove friction points and increase automation throughout commodity markets.
As a transactional record-keeping electronic ledger, blockchain has the ability to ensure that collateral records cannot be duplicated, manipulated or faked; its electronic record-keeping and transaction processing system allows all stakeholders to independently track documentation through a third-party platform, contrasting heavily with the current paper-heavy, lengthy process involved with documentary presentation and collection.
Blockchain technology and distributed ledger systems present the commodity industry with the potential to save billions of dollars in transactional and documentation costs. In addition, adoption among trade finance banks and their clients could significantly lessen the risk posed to capital providers by misstated, duplicated or fraudulently pledged collateral, providing substantially more transparency in their collateral position and – more importantly – lowering the industry’s overall cost structure.
Several trade finance banks have taken note and are experimenting with this nascent technology. First, in September 2016, Barclays laid claim to the first-ever blockchain-based trade finance deal. The deal utilized a documentary letter of credit (LC), payment guaranty and collection instrument that typically involve a complicated, lengthy paper trail. While cutting the documentary process from 10 days to 4 hours, Barclays’ blockchain deal structure supported LC issuance, goods export and payment collection of almost $100,000 worth of cheese and butter from an Irish food cooperative to a Seychelles-based food trading company. The deal was successfully executed on Barclays’ proprietary blockchain platform.
Other banks took notice. In March 2017, French commodity bank Natixis and IBM announced a partnership with global commodity trading company Trafigura to develop the use of blockchain for settling U.S. crude oil transactions. To support the initiative, IBM built a distributed ledger platform called Hyperledger, which is currently being used for trade simulations. By bringing the buyer, the seller and their respective banks onto the same ledger platform, all parties are able to simultaneously view, share and validate data integrity on the status of a transaction from the point of its initiation and confirmation to its final delivery and LC expiry. Having each participant in the supply chain verify each entry (or block) made by other participants in the chain provides indelible data about the trade, with data integrity supported by the number of third parties that have verified it. Slowly but surely, blockchain technology approaches the function of an exchange by providing its trading counterparties with the comfort that their trade will settle properly. In so doing, blockchain technology reaches beyond simply offering execution surety by also providing assurances on traceability. In IBM’s trial, the creation of transparent transactions using a shared process and ledger allowed blockchain to improve process efficiency for Trafigura and Natixis while reducing the threat of transaction tampering, fraud or cybercrime. James Wallis, the vice president for Blockchain Markets with IBM, is optimistic about the platform’s future: “The approach we are taking [with Natixis], using a blockchain network built on the Hyperledger Fabric, has the potential to transform the crude oil industry by creating consistency in trade finance and by digitizing transactions and information sharing.”
While trade execution in capital markets (currency, debt and equity) has long since transitioned into the digital age, commodity markets have not caught up, relying heavily on paperwork and documentation instead. Despite technology available to fix that, commodity market participants have been slow to leverage it. Industry adoption of peer-to-peer database technologies could reduce paperwork and transactional costs, remove friction points and increase automation throughout commodity markets. Indeed, blockchain technology has the potential to simplify many complexities in today’s commodity banking environment. But does it have the ability to displace commodity banking as we know it?
We think it will not. For the foreseeable future, we believe paperwork will continue to dominate the global trade of commodities. Despite technological advances, the cloud is unlikely to take the place of relationship banking any time soon. In closing, we leave you with some thoughts from Senior Vice President Richard Fodder in our Investor Services business, where Brown Brothers Harriman (BBH) sits at the forefront of asset servicing technology:
|Presently, market commentators suggest that advances such as blockchain are creating a revolution that will disintermediate banks from their customers. One area cited as ripe for overhaul is the securities processing industry. But how many times have we heard over the past 25 years that global custody is dead? And yet, it remains. Is this time different? Our view is that it is not. Blockchain and cloud technology represent a natural technological evolution – not a revolution – that will continue to highlight the core competence of banks, namely risk management.|
While paperwork is likely not going anywhere soon, the BBH Commodities & Logistics group will continue to evaluate how blockchain may complement or streamline existing systems and processes.
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PB-2017-08-11-1621 Expires 08/31/2019