Trade Financing is Broken

The æternity blockchain can fix it

(Co-author — Nikola Stojanow)

The current system of trade financing has served us well since 1500 BCE when the Phoenicians, trading between ancient Egypt and Mesopotamia, founded it, but it has become too bureaucratic, full of inefficiencies, open to fraud and expensive.

The æternity blockchain aims to significantly improve the classic trade model and, most importantly, make the trade financing system fit for the 21st century.

Perhaps, to appreciate how inefficiently the old system works, we should do a run through it.

Jessica’s story

Jessica owns a kids store in New York. In order to get good profit margins, she decides to import toys from Guangzhou, China. After doing her research on suppliers, she signs a sales contract with Wang Wei, a supplier.

There are several reasons why Jessica and Wang Wei can’t automatically trust each other, though. If Jessica wires the payment for the goods before they arrive, she can’t be sure Wang Wei will honor the contract. He might as well fail to ship the goods and keep the money. On the other hand, if Wang Wei chose to go first on the contract and ship before Jessica makes the payment, he isn’t guaranteed she will pay.

It is for these exact reasons that a trade financing system evolved over time. It was created to protect both the buyer and the seller who find themselves in this international trade scenario. Trade financing provides credit, payment guarantees and insurance to the parties involved through established financial institutions.

In that system, Jessica will need to apply for a letter of credit from her bank, which is one of hundreds of pieces of papers that the transaction will accumulate over its life.The letter of credit will guarantee Wang Wei that a bank has taken it upon itself to pay him once he presents documents proving he shipped the toys to Jessica. The bank that drafts the letter of credit becomes the issuing bank and substitutes its creditworthiness for that of the buyer. The issuing bank is not the only bank in this transaction.

Current costs of trade

The issuing bank has to send the letter of credit to Wang Wei’s bank in China, signalling to him to ship the goods because the payment is now guaranteed. Wang Wei’s bank becomes the advising bank.

But that is not all. There is also the nominated bank, which will pay Wang Wei through the advising bank on behalf of the issuing bank. Finally, there is the confirming bank that will authenticate the documentation Wang Dei presents.

Obviously, each of these banks is selling “trust” to Jessica and Wang Dei’s transaction, and will take a cut for it, driving the transaction cost up. In fact, the US Department of Commerce has reported that for every $1 million worth of goods businesses import into the US, the businesses spend an average of $43,568 in costs for trade finance.

If there was a system that can enable international traders to securely transact with one another without going through guarantors, the cost could come down significantly. What’s more, the time it takes to transact will also shorten. In fact, Barclays bank, one of major players in the international trade financing, projects that the blockchain technology can cut the time it takes to complete a trade transaction from twenty days to under four hours.

These efficiency gains are exactly what the æternity blockchain can achieve.

Lowering the Costs

On the æternity blockchain, Jessica and Wang Wei can create a private transaction channel, which uses smart contracts to protect them from any scam attempt or failure to honor contracts. No paperwork is needed and therefore there’s no need for an expert to authenticate any documentation.

The two parties do not have to record every transaction on the blockchain, however. They need to announce only the first transaction in order to commit the funds to the channel. They can then transact numerous times and only update their wallet’s final balances on the blockchain when they no longer need to continue transacting, or if they have a dispute. In the latter event, the blockchain will serve as a court or final arbiter.

Why is the æternity blockchain the most suitable to fix trade financing?

Fast, secure and scalable

Both bitcoin and Ethereum blockchains settle transactions in batches, with a cap on the number of transactions they can confirm in a specified time. This slows down operations, especially when there are high volumes oftransactions.

What æternity blockchain developers have done is to enable Jessica and Wang Wei to create a smart-contract secured state channel and transacts off-chain. This allows users to update their off-chain balances, unlimited number of times, without any need to wait for the blockchain consensus to confirm transactions. Transaction speed is limited only by bandwidth. Moreover, peer-to-peer transacting off-chain can be conduced in parallel, so the æternity system can scale as well as the centralized solutions available today.

Another feature that state channels make possible for decentralized architectures is the significantly increased level of privacy. Public blockchains usually reveal details about all transactions. Using state channels, parties can choose what data to broadcast to the network and what not to.

Finally, perhaps the most revolutionary feature of the æternity blockchain is the oracle. This is a virtual machine that crowdsources real-time answers to specific questions using principles of prediction markets. The value this adds to trade financing is that it makes it responsive to market trends in real-time, for example, having the contract live to currency volatility. The oracle also can be used to negotiate fundamental changes to how the system functions, allowing for high adaptability to market demands and developments.

In the end, Wang Wei and Jessica do not need to involve any third parties in their dealings nor to complete tons of paperwork, without sacrificing piece of mind or speed of deal closure.

By using state channels, off-chain smart contracts and the oracle, the æternity blockchain has the potential to make finance trading much cheaper while at the same time faster, more private, secure and flexible.

æternity is currently ramping up its efforts to bring this use case to reality. Stay tuned — sign up for our newsletter.