The Supply Chain Blockchain: how to guide by Alexandre Tabbakh

Though LR-Physics is not currently working on a Supply Chain Blockchain project, we are always looking for opportunities to enrich our Supply Data Science projects.

(source of the blockchain reflexion: Alexandre Tabbakh on LinkedIn who did a great work going through all the Supply Chain Blockchain details)

Supply Chain Blockchain XNotes
(source of the blockchain reflexion: Alexandre Tabbakh on LinkedIn who did a great work going through all the Supply Chain Blockchain details)

One of the first move a large firm makes in order to tackle complicated and time-consuming process of managing paper-based multi-party contracts is to invest into better ERP softwares. It might explain how the size of the supply chain software industry has grown in recent years to over $10billion.

The Supply Chain Management processes involves various companies and institutions, each focused on a step in the chain, such as processing and manufacturing, freight forward/inward, customs checks or quality control.

Trade Finance involves multiple types of financing with different specificities, pain points and types of documents. The distributed ledger technology could for instance be used to digitise invoices and other legal contracts as well as enabling real time localisation of goods, and enhance payment processes. Potentially, business transactions can be executed directly into the platform through the use of self executables, also known as “smart contracts”.

A healthy cashflow position is fundamental to generate sustainable growth. It is especially true for SMEs in Asia-Pacific that are accounting for the majority of both employment and production. They need a smooth and quick access to short-term funding in order to grow and develop their ability to invest and innovate. Whilst supply chain and logistic may seem to have efficient workflows due to the use of Enterprise Resource Planning (ERP) softwares, SMEs cannot afford these costly solutions and need to manage and track most of their operations manually.

Companies have tried to improve the way they operate by investing in advanced reporting software, e-invoicing, payments solutions, cloud and supplier networks (SEPA regulatory requirements), delivering some improvements in processes and day-to-day operations but a lot more needs to be done in terms of end-to-end workflows.


1) What are the current bottlenecks?

From the extraction of the commodity to the production and the distribution of the end product, multiple complex actions and creations of document take place. The time spent to reconcile and bear the burden of the following bottlenecks may divert some of the workforce’s capabilities from other value added tasks, but as well represent an impediment to business development.

  • Multiplicity of sources of information. Each party maintains its own ledger systems, thus creating duplication of effort and cost.
  • Old communication channels are still used to exchange about contracts, invoices, letter of credits, bills of lading and other documents among parties (e.g. fax, mail, phone call…). The storage and the management of all these physically issued documents often represent a significant amount of paperwork.
  • Reconciliations and audits need to be constantly performed in order to keep the quality of the data under control.
  • The participants need to optimise sources of information but also adopt a more standardised and established communication ecosystem. Documents languages, formats, sizes and other features need to be harmonised to smoothen their understanding among parties that might be from different continents.
  • The current trade finance lifecycle allows for fraud to seep in. Documents are stillunsecurely transferred (e.g. unsecured email or fax). Invoices, bills of lading, letters of credit may be falsified without a solid distributed ledger among the parties.
  • The current processes of setting up an escrow account, transferring collateral and releasing funds is far from being automated. Documents that are in paper form make investigation, reconciliation and automation cumbersome and costly. A single asset may be pledged several times for multiple transactions due to the lack of proper controls. The risk posed by fraud in the $4 trillion trade finance industry encourages banks to explore distributed ledger technology.
  • The manual KYC and AML screening processes, as well as the infrastructure cost of maintaining an accurate and updated KYC database represent a serious pain point. The client onboarding involves managing a high number of staff and performing multiple redundancies.
  • In regions where trust between entities, including companies and governments is low, lack of trust often leads to rely only on known and reputable entities for trading relationships. It also prevents from exploring new partnerships with other suppliers as well as creating new synergies.
  • The current supply chain model is slowing the pace of R&D departments.Innovation labs must deal with the complexity and lack of efficiency of the current supply chain processes, causing delays and cost escalation in innovation projects.
  • Operating costs are high as it requires time and a responsive workforce to handle manual and time sensitive processes. Transaction capture accuracy and timeliness are crucial factors in the management of goods (especially perishable goods). Any manual miscalculation or miscommunication may create a settlement failure, affecting the participant’s reputation and causing financial penalties.

2) Use Cases and Workflows

a) Supply Chain Minting and self-executables (more commonly known as “smart contracts”, which executes preprogrammed actions based on predetermined conditions).

The workflow commences with the minting of Digital IDs, corresponding to actual physical goods and certificates. It will have the following data points:

  • Location via GPS tracking
  • Date and time
  • Pictures
  • Size, dimensions, weight
  • Mechanical properties
  • Chemical composition
  • Lot size, quantities
  • Type of certificates

To ensure accuracy of the data points and transparency in verifying information, exporters/importers, transporters, terminals, customs and controllers will all ideally be nodes on the blockchain and perform the validation of the Digital IDs in a systematic manner.


BLOCKCHAIN BASED SUPPLY CHAIN LOGISTICS

SUPPLY CHAIN STAKEHOLDERS

The creation of the “minted quantity of goods” onto the blockchain takes place immediately after the validation between the exporter and importer. A significant advantage of this proposed Supply Chain blockchain-based workflow is in the increased traceabilitythat it provides, since the physical goods are monitored from the beginning of the supply chain via the Digital ID validation series.

Each minted quantity of goods represents an immutable timestamped record that may be recalled in case of dispute and litigation. Blockchain immutability and traceability are seen as key functional attributes for improving efficiency in the supply chain process of tracking the change of ownership of goods. The blockchain must allow every participant on a supply chain blockchain network to track sourcing and provenance of materials but also maintain immutable records of the production and storage of finished goods.

For example, goods sensitive to heat, such as pharmaceuticals, food and other perishables, could be monitored during transport through a GPS and a connected sensor advising if the cargo journey was compromised and triggering claims, or premium recalculations. Linking physical goods to serial numbers, bar codes or QR codes helps the consumers to trace the exact origin of a product.

Digitising a client ID and sharing it inside the various silos of a bank through a distributed ledger is the first step towards reducing overheads and risk. The second step is for a blockchain-based network to become a trusted utility where a client may permission the access to various counterparties.

Digitising the various documents involved in trade finance significantly reduces the opportunities of misappropriation of funds, carry trades, documents falsification or overcollateralisation.

The extent of access of each participant may vary depending on permissions applied on the different categories of nodes. For instance, the regulators or customs may be provided with a privileged viewing access as compared to others, thereby reducing the need for regulatory reporting and manual fill-up of forms.

Given the high potential of fraud, invoices and quality certificates (e.g. ISO certificate) are considered as leading candidates in blockchain applications. Allowing the banks to transform these documents into digital assets with identities on a decentralised distributed ledger will stimulate the trade finance industry to evolve into a new digital era.

Invoices may as well be tokenized once approved by a buyer. The real interest of the token is to add a layer of security on the top of the secure blockchain cryptographic technique. The details of the document are partially hidden on the blockchain and a full read access to third parties might only be given upon special approval from the supplier for instance. Upon receiving the digital token, the final recipient, whether a bank, distributor or customer verifies the chain of custody from the point of origin. Approved payables are split up in a multi-lender marketplace and lenders are able to purchase parts of invoices to minimise risk, lowering the cost of capital to the supplier.

The opportunity for new peer-to-peer lending-invoicing platforms emerges from this new secondary invoicing ecosystem. A bank may for instance run an online platform that brings together businesses and banking customers. Businesses may place their financing requests on the platform and banking customers would state which loan they wish to co-finance. Blockchain adds transparency and security to these platforms.


BLOCKCHAIN BASED SUPPLY CHAINS ECOSYSTEM

Collateral management is an increasingly important tool in trade finance. SMEs face hurdles in obtaining financing because they have less collateral, guarantees, and credit history than larger companies. Hence, collateral can be an important factor in determining SMEs contribution to economic growth. In addition, the absence of a totally secure and shared ledger maintains a dangerous systemic risk considering the possibility of multiple fraudulent pledging of the same assets.

Banks and other funding providers rely on creditworthiness. Companies trading through blockchain-based supply chains could obtain faster credit scoring by granting a permissioned access to banks or lenders. The inherent transparency of a blockchain thus becomes essential for bringing confidence in the marketplace and among lenders, as well as confidence to make investments. The distributed ledger technology and the issuance of a unique digitally authorized ID, bring the opportunity to streamline and optimise KYC and anti-money laundering (AML) compliance procedures. Instead of sending all the data to the regulators proving that an AML follow up has been performed correctly, the bank may demonstrate regulators that they have automatic procedures that monitor AML, and generate report suspicious transactions.

The end user, potentially the most influential among all the participants of this blockchain-enabled ecosystem, will ultimately experience the benefits of this blockchain adoption. Blockchain prevents any party from altering or challenging the legitimacy of the information being exchanged, thereby providing more confidence to the end user in purchasing a good that has gone through the process of minting. The greater transparency brought to the current supply chains will allow consumers to make informed purchases and access to more traceable records built all along the entire product journey, from the farm or the mine to the final distributor.

The post-order process is materialised through the use of smart contracts created once there is a transaction agreement. Payments, collaterals, shipment features and other preconditions are all embedded into the smart contract.

Payments:

  • The payments are recorded and secured on the blockchain.
  • Exchange rate may be calculated through the trigger of preconditions (e.g. use the USD/CNY FX rate published on the delivery day at 2pm by data provider X).
  • Advance payments and tranche payments may be set up and automatically triggered (e.g. upon completion of goods delivery).
  • In a closed loop environment, payments are triggered by one single bank, associated to the transaction and a partner of both exporters and importers, as a change of ownership rather than a debit/credit. A digital wallet could be used to generate payments from the bank to the transacting parties.
  • In an open loop whereby more than one bank is a participant node on the network, smart contracts may trigger a message to a core banking system for issuing payments. In that workflow, messages may still be netted or compressed to reduce transaction charges of the banks.

Collateral position and escrow account:

  • The collateral (physical or non-physical assets) is minted into the blockchain in an escrow account, helping the bank or custodian to be aware of any collateral duplication attempt.
  • Returns are triggered automatically once a payment has been received or made.
  • In case of potential margin calls, they would occur real-time, helping to get an accurate position and eliminate assets freezing.

Shipments and other types of deliveries:

  • Freight contracts and bill of lading features may be recorded into smart contracts.
  • A bill of lading may be set up with a “forward start” feature, meaning that the document will be generated for instance upon completions of certain payments or collateral sanity checks.
  • The shipping companies are nodes (members) of the blockchain and able to receive and validate bills of lading through the blockchain. It will optimise the time between the transaction payments and the transportation process commencement.

b) Focus on Letter of Credit

For letters of credit, banks require every word, name, date and details to be as specific and as clear as possible. Shipping a day late or misspelling a name may cause the bank to refuse paying until a new letter of credit is issued and accepted.

A letter of credit is a legal document representing a financial institution’s promise to pay the holder upon the fulfilment of certain obligations. A seller can require a buyer to provide a letter of credit before shipping its product. Banks may require a pledge of securities or cash collateral in order to issue a letter of credit to a holder.


CONVENTIONAL LETTER OF CREDIT PROCESS

  1. Contract of sale stating payment methods through a Letter of Credit.
  2. Buyer instructs his bank to issue a letter of credit in favor of the seller.
  3. Issuing bank arranges with a bank in the seller’s country to advise the seller when the letter of credit has been issued and to pay against delivery of shipping documents.
  4. The advising bank informs the seller when the letter of credit has been issued and which document should be provided settlement.

LETTER OF CREDIT PROCESS WITH BLOCKCHAIN

Blockchain technology with the use of smart contracts can help to solve some of the main issues:

  • The process today is highly manual and requires the reconciliation between several independent records on each entity involved – Buyer, Issuing Bank, Advising Bank, seller. This gradually goes away when a single, trusted and validated record gets permissioned and distributed.
  • The blockchain could be the shared source of truth and workflow engine to automate the process and provide cryptographic security.
  • Smart contract would automate payments upon fulfilment of obligations.
  • A more transparent and efficient secondary market could emerge through the digital transfer of ownership.

c) Focus on Accounts Receivable Factoring or Invoice Factoring

In factoring, multiple manual checks are performed. Documents are often manually completed and sent via unsecure channels. Any inaccuracy may affect the information quality, cause delay on applications, or even result in rejections. Factoring is a common trade finance offering provided by banks and other financial institutions. It involves a bank paying the seller of goods before the buyer makes the payment.

For all parties, factoring and reverse factoring involve multiple risk factors including nonpayment, duplicate payment, misrepresentation and even fraud. By permissioningthe access to his invoices or tranches of its invoices, the supplier in the diagram below is able to broadcast its invoice real-time and digitally in order to obtain the best factoring rate possible on a peer-to-peer invoicing or debt marketplace. Members of the marketplace may be banks, brokers, SMEs, insurers or even individuals who would be willing to use their cash to get better rates than those offered in the current low yield environment. Invoice financing is advantageous to customers seeking short-term loans for working capital requirements.


CONVENTIONAL FACTORING PROCESS

  1. Seller supplies goods and services under a contract of sale.
  2. Buyer owes a debt to seller (invoice is generated).
  3. Factoring agreement is made between the factor and the seller.
  4. Seller gives notice of assignment to the buyers.
  5. The buyer owes a debt to the factor.
  6. Factor makes a prepayment of the invoice (at a pre-agreed price)
  7. Debtor pays debt in accordance with the invoice on the due date.
  8. Factor pays the remaining part of the invoice to the seller (discount included).

FACTORING PROCESS WITH BLOCKCHAIN

  1. Seller supplies goods and services under a contract of sale.
  2. Buyer owes debt to seller (invoice is generated).
  3. Seller finds the most advantageous interest rate.
  4. Seller serves notice of assignment to the buyers.
  5. Payments are disseminated through the platform.

Conclusion

The use of the blockchain technology in supply chain logistics and trade finance brings several advantages:

  • Improved KYC/AML processes with an optimised onboarding of SMEs and financial institutions.
  • Onboarding done once and periodic reviews being automated (alert created if documents are to expire, chaser sent automatically to request latest documents).
  • Minting Digital ID of incumbents directly on the blockchain, creating a single piece of data for each participant.
  • Less paperwork to administer.
  • Less data reconciliation, scrubbing and replication.
  • Traceability of the quality attributes from the point of origination (such as grade, country of origin, or whether or not the raw materials have been extracted or harvested sustainably), through tracking and verifying at any stage of the lifecycle.
  • Tracking of containers’ weight and journey.
  • Positive social impact of smoother access to liquidity for SMEs.
  • Increased transparency and visibility of the movement of physical goods.
  • Ultimately, no more documents to be warehoused (cost reductions in Warehouse Management Systems).
  • Automated payment scheduling.
  • Accurate and automated escrow management mechanism, with monitoring and control of overcollateralisation.
  • Direct access for regulators, quality inspectors and customs agents, enhancing market surveillance capabilities.
  • Immutability, tamper-proof resistance of issued documents.

Despite all the hype surrounding Blockchain, the adoption of blockchain-based Supply Chain Logistics and Finance ecosystems will be facing significant hurdles.

First even if I believe in the inevitable interoperability of the different blockchains (from different blockchain network providers), the creation of new standards will be required on the market, (e.g. determine which criterias are necessary to validate a LC, BoL, BADD, etc). Secondly, blockchain solutions providers, regulators and legal departments will have to collaborate amongst themselves and all other involved parties in order to standardise and define the legal scope and responsibilities of each nodes into a network.

We are currently in the phase of proof of concepts that will most likely continue in 2017, but real operational solutions might be implemented sooner than expected and probably not from the institutions we expect the most.

The best candidates are probably in developing countries. They are more and more leveraging on technology to provide more efficient and cheaper financial services. They are also likely to make use of the distributed ledger technology for “financial inclusion”, which would ultimately give a boost to SMEs productivity. 

Some fintechs also target these countries for the difficulties financial firms meet in the credit scoring processes of SMEs. It is currently tough for credit scoring firms to obtain a viable assessment of the payment history, the data being rare or sometimes nonexistent.

If you want to know more about Supply Chain Blochchain

Please refer to Alexandre Tabbakh at XNotes, or contact us.

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