How blockchain can transform supply chain finance

Blockchain technology can affect supply chains significantly, whether they pertain to commodity trading, the production of cars or book publishing.

In the current method of doing business each party in the supply chain purchases goods, adds value and sells these good to the next party in the supply chain. This process requires the financing of inventory and the necessity for third parties to either finance or at least process a transaction.

In contrast to this traditional way of doing business, parties can work smarter and as a result reduce costs significantly using blockchain. Payments in a supply chain can be triggered by a certain, predefined action, occurring at any point in time. This article explains blockchain and outlines how it can impact on the financing of supply chains.

Blockchain explained

Blockchain technology allows two parties to transact, without making use of a central authority of third party intermediaries. In other words: there is technology available that can allow you to trade directly with any counterparty around the world, in a secured, fast and cost efficient manner.

It consists of three key components: a transaction, a transaction record and a system that verifies and stores the transaction. Open source software is used to generate and record information about the transaction; when it took place and the chronological order of all transactions. This results in a chain of information, stored in so-called ‘block’; hence the name ‘blockchain’.

Linked to the information, so-called smart contracts can be attached, by using hashes. These smart contracts can represent, for example, a contract or a ownership title. It can also represent physical goods, via a barcode or quick response (QR) code. Users
can access the blockchain via a web interface and have a wallet in order to communicate with each other. Data storage is decentralised; the information is tamper-proof and visible for all parties involved.

Blockchain technology is already widely used, the most famous application of it being Bitcoin. This is a so-called cryptocurrency, a digital currency that is used as an alternative money system, besides ‘normal’ currencies such as the euro (EUR) or US dollar (USD). The attractiveness of Bitcoin is that there are extremely low processing fees, simply because there is no intermediary involved in the transaction.

Bitcoin has a proven track record but there are also other areas where blockchain technology is useful: it can be used to provide notary services and recently 11 major global banks announced they will test a trading system, based on blockchain technology.

Blockchain applied to Supply Chain Finance

Having outlined the basics of blockchain, how can this be applied to supply chain finance (SCF)? It is important to understand that supply chains are complex by nature; various parties are involved from raw goods supplier, producer and distributor all the way up to the consumer.

Generally speaking the parties in a supply chain are located in various countries. Each party in the chain takes care of financing its own working capital and inventory. SCF is a generic term for a wide variety of financing instruments, used to finance various parties in a supply chain.

In actual trade between a buyer and seller in different countries, the most common used instrument is the letter of credit (LC). This makes for a cumbersome process: costly (costs range around 2-4% on annual basis), prone to error and involving a financial intermediary to process the transaction. The great advantage of LCs is that payment is secure and guaranteed (by the banks). Table 1 below outlines how an LC works when a buyer (applicant) and seller (beneficiary) trade.

Image 1: mechanics of Letter of Credit.
Table 1: Mechanics of a Letter of Credit

The main advantages of a LC is that a payment is guaranteed and also secure, offsetting in part the disadvantages of being costly and cumbersome. By making the use of blockchain technology more specific via smart contracts, the advantages of a LC remain but the disadvantages are taken away.

In general this works as follows: two parties agree to trade goods, and the selling party receives via his wallet a confirmation that he will be paid at a certain point if time. This guarantee is conditional, based on predefined criteria. The container with the goods contains a QR code, this is linked to a smart contract. When the goods arrive at the agreed point, and the pre-defined criteria are met, the smart contract is executed.

This triggers the transfer of ownership to the buyer and payment to the supplier is executed automatically. The great advantage is that when the structure is set up, the costs for a transaction are minimal. They are comparable to physical mail (for example €1 per letter) versus e-mail (a negligible cost per item).

This way of financing a supply chain is radically cheaper and more efficient than the current way of doing business. At the same time the required security and guarantees remain intact. The technology is available, although some caution should still be exercised. The Bitcoin has been around since 2012, so in principle blockchain is proven technology. However, the above example would require a different blockchain than that used for Bitcoin.

There is huge interest in this new technology, but in practice only a handful of corporates worldwide trade according to this example. The potential benefit is clear to all, it allows massive simplification of (banking) processes and significantly reduces costs.

To sum up – blockchain technology can offer great potential for corporates: increased control, speed and reliability of their supply chain and at a fraction of the cost of their current infrastructure.

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