Alpine Style investigates how blockchain, data and decentralisation are reshaping the trade finance sector. In Part 1, we looked at blockchain consortium initiatives, their evolution and limitations. In Part 2, we focus on decentralised finance (DeFi), a sector that is trying to bring liquidity to the ‘blockchain for trade finance’ equation.
DeFi for trade finance: the promise of virtually unlimited liquidity
By now, most people in the trade finance sector are familiar with blockchain or distributed ledger technology (DLT). But while traditional players are using it mostly to increase transparency and reduce fraud risk, a growing number of digital natives are choosing to explore blockchain’s liquidity potential: decentralised finance (DeFi).
While in traditional or centralised finance, a person or company places their trust and their assets in a financial institution, which handles them for a fee, DeFi is a ‘trustless’ financial system where intermediaries are removed and individual users are in charge of their investments. The promise is clear: removing banking fees and giving everyone with an internet connection access to complex financial instruments, in the form of DeFi applications (dApps).
In order for it to be truly decentralised, the system should work with cryptocurrencies: people use their euros or dollars to purchase digital assets, which they hold in a crypto-wallet. From there, they can execute a number of different transactions on chain, from lending and borrowing to trading their coins on decentralised money markets.
“Just by placing assets with a custodian and providing them (liquidity) to an exchange, you could earn 20% on a money market account, which is currently unheard of in the traditional finance world,” says Michael Burgess, COO at Ren, a decentralised protocol that allows for the conversion of digital assets between various blockchain platforms.
Because digital asset holders can earn passive income simply by making their funds available to others, there is incentive to increase the overall liquidity available in the market, which could tremendously benefit the trade finance sector, infamous for its US$1.5tn funding gap.
Trade asset distribution on chain
The most immediate application of DeFi in the trade finance sector is in the form of trade asset distribution or securitisation. The creation of a trade asset class has long been seen as a potential solution to the lack of liquidity in the market: banks and other trade finance originators would take on the risk in a transaction between and importer and an exporter, then go on to sell this risk to secondary market investors, freeing up their own balance sheet and making space for more transactions.
In the past, this has been done in the form of large-scale trade securitisations, whereby the bank bundled up its trade finance assets and sold them in tranches with different risk profiles. One famous example of this is Deutsche Bank’s TRAFIN synthetic collaterised loan obligation, which was launched in 2015 at US$3.5bn, and refinanced in 2018. However, this is not common practice, and when it happens it is done on a very large scale, perhaps to justify the amount of work required to make such a deal happen.
Another way banks are looking at selling their trade finance assets is on a portfolio or individual transaction basis: last May, HSBC announced that it would team up with Allianz Global Investors to wrap its trade finance assets into notes, transaction by transaction. As the pursuit of the originate-to-distribute model accelerated, players like Tradeteq emerged in recent years to connect trade finance originators to global investors through high-tech platforms.
DeFi could propel efforts to distribute trade finance assets, and one of the main players in this space is Centrifuge. The company is building a framework for asset originators to create credit pools and present them to investors in two tranches — in other words, conduct simple securitisations on chain. The company aims to tap a decentralised network of underwriters, and to separate underwriting from investing, bringing more competitiveness into the market. The platform has been live since May 2020, and has so far settled 109 transactions with four different asset originators, generally invoicing networks, freight forwarding platforms or any firm that holds trade finance assets and is working to use cryptocurrency as a funding source.
“For each of these pools, there’s a legal counterpart, a special purpose vehicle that has a legal relationship with the borrower. Each asset, invoices, letters of credit, etc, is represented by a non-fungible token (NFT) on chain. You can then move these NFTs into the pool to get them financed. On the other side, investors might buy an ERC20 [Ethereum’s standard token] that represents a share of that pool,” explains Lucas Vogelsang, CEO and co-founder of Centrifuge.
The goal of using such a structure on a decentralised basis is twofold: first, it helps asset originators diversify their sources of capital, way beyond what would normally be accessible to them. Second, by creating competition in the market, it also lowers the cost of access to this capital, with the cost savings likely to be passed on to the originators’ clients — generally small and medium-sized corporates.
Singapore-based XinFin (powered by its XDC token and the DeFi protocol Tradefinex) is another company working to enable trade asset distribution on the blockchain, by collaborating with a wide array of asset originators — including banks. XinFin records obligations from buyers to pay suppliers digitally, collecting them from ERPs, accounting software or even digital LC providers (the firm is in talks with Contour Network), using a smart contract that is legally enforceable in offline courts. The obligation then becomes a tokenised instrument that can be financed with DeFi liquidity, generating yield in the investor’s crypto-wallet.
“The size of trade finance instruments is massive, and if we do this right, there’s no limit. We aim to be a middleman able to connect the different platforms, and then let the world of alternative investors build liquidity into these markets,” says Atul Khekade, co-founder of XinFin.
The company aims to build and scale up trade finance infrastructure in a decentralised way: the XinFin network runs in a decentralised format, whereby anyone can become a node and part-owner of the network, participating in its governance and generating income. “It’s a structure that eventually the big originator funds may come into,” he adds.
Financial institutions can participate as originators, tokenising their obligations to pass them on to secondary investors; or as investors themselves. Among the originators XinFin has approached two large Asian trade finance banks, as well as a P2P originator that facilitates finance for SMEs and directly backed by the Singapore government.
Corporates as originators
Under the XinFin and Centrifuge models, trade finance assets are placed on a DeFi platform by an originator, be it a bank or an alternative financier. But what if corporates themselves could finance their receivables directly? Khekade believes that buyers and suppliers could become originators on the platform at some point.
He notes: “As a supplier, you can just upload an invoice that is verified on the other side by the purchase obligation, and get liquidity in your wallet. You just need to open a KYC wallet and get access to liquidity, so the onboarding isn’t so difficult for smaller participants. There’s no reason why a corporate itself cannot be an originator on the platform, and we are comfortable with the level of risk that the platform can work with.”
If you think it sounds too good to be true, you’re not alone. At Centrifuge, Vogelsang believes that we are “many years away from a product where end users are able to borrow money from crypto,” due to the complexity and risk associated with owning and trading cryptocurrencies.
There are many obstacles to the direct financing of corporates through DeFi. First, cryptocurrencies tend to be over-speculated, and their volatility is likely to scare many brick and mortar businesses, including banks. Crypto is also difficult to trace, and because of that, losses are hard to recover. For instance, on September 25, 2020, when the Kucoin exchange was hacked, an estimated US$280mn of ERC20 tokens were stolen, bringing many DeFi projects to a halt. “If you lose your assets in the DeFi world, they’re gone, there is no one to sue and no repercussions,” says Burgess at Ren.
More and more central banks are working to create their own digital representations of fiat money, and the broad adoption of these CBDCs (Central Bank Digital Currencies) could remove some of the risks associated with crypto — but it would also reduce the decentralised characteristic of DeFi.
Second, bringing real-world assets into the digital realm is harder than it seems. Perlin, a blockchain development firm working with the International Chamber of Commerce (ICC) to create trade finance DeFi applications, is trying to create a blueprint in the commodity sector, which it considers an easy use case, before expanding the model to other types of assets.
“What underlies all of it is that you would tokenise or create digital representation of the underlying asset. You would have your coffee bean shipment, tokenise it so it’s in a form that can interact with the blockchain, and then you would make that token available to people who wanted to bet on the price of those coffee beans. In simple cases, they put up the tokenised coffee beans, the letter of credit is the collateral, if the shipment gets to its destination, the position closes, and the financing is repaid with interest that would be significantly less than the rates an SME would obtain from a major bank,” says Darren Toh, head of communication and compliance at Perlin.
As seen in Part 1 of this series, a letter of credit is the type of instrument that can easily be digitised, since it is standardised all over the world. But first, the digitisation has to happen, which isn’t yet the case in the majority of cases. “For our first pilot, which was a US$25mn shipment of iron or from Africa to China, the shipment got there before the documents, which is absurd. So you have to digitise the LC at the point of origin and secure it on the blockchain,” Toh adds.
Additionally, relying on LCs as collateral would mean that DeFi liquidity would be reserved to companies who already have access to trade finance from banks, leaving out the bulk of small and micro-businesses that form the US$1.5tn trade finance gap. XinFin is integrating data from IoT devices into its platform, in the shape of non-fungible tokens or NFTs. “Whatever you control on that device, you can control on the network, so that it replicates its behaviour. For example, the temperature of a container, you can have sets of rules to define it, or if your supplies are delivered in another part of the port, you can mitigate the risk for your trade finance,” says Khakede.
Indeed, IoT integration could allow the goods themselves to be used as collateral for the financing of trade on DeFi platforms, unlocking DeFi liquidity for open-account trade. But the sector is far from having access to the number and variety of IoT sensors that would be necessary to follow a good from production to destination. Not to mention, regulation would be needed to frame such a practice and make smart contracts involving this kind of collateral legally enforceable.
Regulation sometimes has a way of stifling innovation, or at least of shaping its geographic spread: when Australia started regulating blockchain with a heavy hand, Perlin’s Toh moved to Singapore, where the company is working with authorities in regulatory sandboxes. “Regulatory risk is in the top range of things that scare us,” he says. “Regulation is a good thing, but the fear is overreaction and overregulation. The reality is with regulation and blockchain, many governments still struggle to properly regulate it to allow innovation to happen and without suffocating the space.”
For this reason, many DeFi players are based out of Singapore, Switzerland and parts of the EU where regulators are more amenable than elsewhere, but with a business as global as DeFi, particularly in the context of trade finance, it is impossible to operate in a regulatory bubble.
“The missing piece to all this, which I think will come in the medium term, is this real-world representation of products moving around, an infrastructure system that can record those in a consistent, universal way and apply all the different regulatory requirements for each jurisdiction — that’s the tricky part. Creating a system that’s flexible enough to navigate different regulatory requirements, but universal enough that anyone in the world can use it. Unless you have a regulatory body and an enforcement mechanism that works on a truly global scale, I don’t think we’ll really have that true fluidity between the real world and the digital world,” says Burgess.
One of the positive outcomes of the coronavirus pandemic is that it bumped the digitisation of most processes much higher on everyone’s agenda. For Khekade, this has helped XinFin move closer to its market fit. “We were looking more towards the future initially, but with Covid, the responsibility from the big corporates and banks is there now, and they are more willing to take a step forward and innovate to meet with the liquidity issues. Now there is more intersection between the DeFi world and the traditional banking world, and that will grow and make us more scalable,” he says.
CeFi vs DeFi for trade finance
It is hard to compare apples with apples in centralised finance (CeFi) and decentralised finance (DeFi), but here are a few figures to illustrate the difference, and the potential of the decentralised approach:
There may still be many question marks around the potential to bring trade finance to DeFi, but the pace of innovation is accelerating, and it won’t be long before we find out if the liquidity promise of DeFi can be fulfilled. If it can, it will be one of the biggest game changers in the history of trade finance.