Blockchain in commodities financing still facing ‘significant hurdles’

Blockchain in commodities financing still facing ‘significant hurdles’
While blockchain is discussed in increasingly excitable terms, questions still abound as to the real world implications of such a technological leap. Richard Usher, commodities lawyer at DLA Piper, examines the structure of the system as well as the nature of some of the problems it will solve, and those it won’t.

What is blockchain?

Chaining is a database technology that dates back to the 1980s—think of a chain of transactions like a physical chain, with links added one at a time. Just like a real chain, if you pull one of the previous links out, the whole chain fails. The ‘block’ refers to a block of transactions and a blockchain is therefore a database that you can only ever add to.

In essence, it is a tool for maintaining transparent and distributed ledgers that can verify transactions (including financial ones) with minimal third party involvement. Blockchain is distributed in the sense that the ledger is not held in a central location but rather is spread across a network of computers. It is transparent in the sense that every transaction is made available for all those in the network to see.

What is the practical role blockchain can have in financing commodities deals?

Blockchain’s claim to fame is that it solves the problem of trust. If person A wants to send money to person B, how do we know that person A has the necessary funds? Typically, we would need a third party, say a bank, to verify the exchange. But the advantage of blockchain is that it stores an indelible ledger of all previous transactions in a string of ‘blocks’, meaning we know who owns what and who can send what to whom. The Economist describes it as ‘the great chain of being sure about things’.

Blockchain itself will probably not alter fundamentally the way in which international trade is conducted, but it will speed the documentary side of things up and make the process more efficient.

Take a simple ‘free on board’ sale contract of oil under which the parties enter into a sale and purchase agreement, with payment to be made by letter of credit (LC). Goods will be loaded on board a vessel and the shipping and commercial documents prepared and presented under the LC. Assuming, not unreasonably, that the cargo is sold multiple times prior to loading, then those documents may have to be presented under multiple letters of credit. Assuming each bank takes the maximum five banking days from presentation as permitted under Article 14(b) of the Uniform Customs and Practice for Documentary Credits, then even four presentations are likely to take at least five weeks to process before the ultimate consignee receives the shipping documents to allow them to unload the cargo—hence the preponderance of discharge letters of indemnity in oil trading.

What blockchain can do in this respect is not to change any of the above in terms of process, (goods will still need to be loaded and shipped and presentations made under the various LC’s) but to speed that process up considerably.

Imagine if once the first bank has examined and accepted the documents as compliant, that all other banks in the chain could see that—arguably they would not then need to check the documents again and each LC could be called and honoured in a matter of hours, potentially allowing shipping documents to be delivered to the ultimate consignee prior to the arrival of the vessel at discharge port.

Is this role limited by network effects, to what extent will the technology become useful only when more players in the supply chain are using it?

It is absolutely key to the wider application of blockchain to trade and commodity finance that all the parties who currently are involved in the process, from banks, trading houses, port authorities, customs and revenue, ship owners, to port and vessel agents are involved. The reason trade finance documentation is so bulky is because international trade is complex. If the chain isn’t complete then it will not be the great chain of being sure of things.

Equally there are three other significant hurdles that blockchain has to overcome:

  • firstly, many traders are traditionally very secretive about their business and the current system allows them to maintain that air of confidentiality, as only the immediate counterparties are privy to information. Getting all market participants comfortable with how blockchain works and the extent to which transactions will or maybe be more transparent to other participants in the chain is going to be a significant hurdle
  • secondly, until international trade itself becomes more digitised, even if market participants want to use blockchain, they will be unable to, as infrastructure is relatively poor in many countries
  • finally, even if one bank or trading house develops a perfect blockchain trade finance model, there will be others who will refuse to use that platform simply because it is owned by a competitor—so any platform that is to be widely used by the market will have to strike a balance between neutrality of ownership and structural and financial integrity

By helping to streamline deals considerably, could blockchain put lawyers out of work?

In a word no. First there will be a significant amount of work in getting blockchain to a stage where it has reached critical mass and as I mentioned at the outset, the underlying transactions will still need to be structured and documented in the same way as they are today. Furthermore, disputes will still arise—of course.

What should commodities finance lawyers watch for next?

At the moment, those few (but growing number of) transactions that are utilising blockchain are relatively straightforward transactions and do not have multiple buyers, sellers and banks involved. Lawyers will need to discuss with clients if blockchain is appropriate for a particular transaction and be awake to the implications of that decision on the structuring and terms of the deal.

Interviewed by Julian Sayarer.

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About the author:

Miranda is a solicitor specialising in leveraged and acquisition finance. She trained at Hogan Lovells International LLP and qualified into the international banking and finance team. During her time at Hogan Lovells she worked on a variety of domestic and cross-border transactions, acting for both borrowers and lenders. She also experienced secondments to Barclays Bank PLC and Kaupthing Bank hf.