Tokenisation of Real-World Assets can bridge the $1.7TRN trade finance gap.
The current Supply Chain bottlenecks has raised awareness of the importance of global trade. It is understood that development is dependent on trading, however the need for efficient processes and adequate financing is crucial. Trade finance represents the financial instruments and products companies use to facilitate international trade and commerce, including the Letter of credit and Bill of Laden. It provides the exporter with receivables or payments based on the agreement that the importer might be extended credit for the trade order. According to the WTO, Up to 80 per cent of trade is financed by credit or credit insurance, but coverage is not uniform.
This system has not changed much in over three hundred years. Indeed, despite decades long efforts to digitalise, cross border trading is still a notoriously complex process and still highly dependent on paper documents. In fact, a cross-border transaction requires numerous processes and on average includes the exchange of 36 documents and 240 copies, with less than one percent of trade documents fully digitised.
Small & Medium-sized Enterprises (SMEs) in the Supply Chain
A lack of trade finance is a significant non-tariff barrier to trade, particularly (but not exclusively) in developing countries.
- 33 percent of SMEs in large developed economies encounter the greatest challenges to secure affordable trade financing. SMEs account for 20 percent of US exports, and 40 per cent of EU exports.
- 50 percent of trade finance requests by SMEs are rejected globally compared with just 7 percent for multinational companies. As a result, the largest institutions and their clients has more access to global liquidity.
- In developing countries, SMEs encounter more difficulties accessing trade finance, with unmet demand being US$120 billion in Africa (33 percent of the market) and US$ 700 billion in Asia.
This persistent gap between supply and demand in the trade finance market has led to a lack of financing for SMEs, impacting global trade and creating inefficiencies and bottlenecks. Bridging these gaps in provision would unlock the trading potential of many thousands of individuals and small businesses around the world. One solution involves leveraging distributed ledger technology, particularly DeFi, to expand credit supply and digitise and standardise some of the processes involved in Trade Finance.
Institutional Lending and access to Liquidity
The key issue is that banks are unable to provide all the corporate financing needed due to the regulations which cover banking operations making it expensive for them to lend to companies. On the other hand, institutional investors are interested in yields above comparable benchmarks. Trade Finance is considered a good asset class as it regularly pays above commensurate yield level given that it is based on the flow of physical goods and services, making it less susceptible to financial market volatility. Default rates for trade finance products are lower and the time to recovery in case of default tends to be shorter than for other credit products.
SMEs also encounter difficulties seeking borrowing due to domestic liquidity constraints, alongside the mismatch between liquidity pools for domestic and cross-border trade which is mainly denominated by a few foreign currencies. Additionally, Cross-border financing for SMEs requires consideration of financial exchange movements, payment controls, and dependence on financial institutions within a few international markets.
DeFi and the tokenisation of Real World Assets
The DeFi ecosystem has the potential to disrupt the traditional financial structures and provide an alternative provision to the increasing demand for credit. The tokenisation of real-world assets (RWA) in DeFi is relatively unknown, however it can become a stable investment option for Financial Institutions looking to expand their portfolios.
Tokenisation is a capability that leverages blockchain technology to securitise assets, both traded and non-traded. Key benefits of tokenisation include increased liquidity, faster settlement, lower costs, and bolstered risk management.
According to the OECD, tokenisation could enhance inclusiveness in markets previously restricted to larger or institutional investors, increasing finance access for SMEs by allowing any type of investors, including retail ones, to indirectly or directly fund SME projects.
The inherent properties of DeFi makes it the ideal ecosystem to enable this as it can expand credit supply, allowing access to financial services via blockchains like Ethereum. The distributed, coordinated nature of the DeFi’s network is efficient and secure which can decrease the many restrictions on SMEs ability to trade, enabling anyone globally to participate in financial services.
What are real-world assets in DeFi
Any asset that exists in the real-world can essentially be tokenised on chain using blockchain technology. For example, this includes equities, real estate, invoices, inventory and many more. Tokenisation then allows the RWA to be verified, valued, and used as collateral.
How do they provide a yield
Capital is invested into pools located on the blockchain by Liquidity Providers (LP), which is backed by tokenised RWAs. Businesses which have submitted assets to the pool are then verified and are able to utilise the capital to conduct business operations. After a predetermined period of time they can then repay the funds with interest. Investors therefore have a stable return collaterised by RWAs and business have access to a line of credit.
The total value of all real-world assets on Earth — every bar of gold, every barrel of oil, every piece of real estate — is estimated to be $256 trillion. Once asset owners are able to record that ownership on a distributed ledger on the Blockchain, they could potentially leverage that wealth to unlock endless opportunities for growth.
Use cases and Innovation projects
The current landscape of projects seeking to bring RWAs into DeFi to improve Trade Finance include MakerDAO, Aavesome, and enVoy. Two specific use cases are:
Centrifuge is a DeFi lending protocol with the ambition of making credit more easily accessible to individuals and SMEs by allowing them to obtain credit by tokenising their physical assets. By bridging assets such as invoices, reals estate, and royalties to DeFi, Centrifuge allows borrowers to finance their real-world assets without banks or other intermediaries. Everyone is able to provide liquidity and investors can receive a return. Equally, investors who provide that credit can earn a stable yield through the interest received on the repayments of those loans.
Centrifuge uses a platform called Tinlake, essentially a marketplace for NFT-based RWAs. The assets are verified by Tinlake and represented on the blockchain, which are then used by their owners as collateral to obtain funding through the marketplace, tapping into liquidity pools provided by Centrifuge’s investor community.
Centrifuge makes a big deal about enabling SMEs to access credit, which in the traditional world of finance is generally restricted to large enterprises. They suggest that a lack of capital is the main reason that most SMEs go bankrupt, therefore allowing them to tokenise receivables enables access to the capital needed to stay in business.
Defactor [Official]* is a global leader in DeFi and also a current partner of the Centrifuge platform. They are at the forefront of the financing revolution and were one of the first platforms to put RWAs on the blockchain. The Defactor Platform offers an opportunity for Asset Originators (AOs) to obtain collateralised funding via DeFi liquidity pools. Its solution reduces barriers to entry for AOs by providing the required funding infrastructure and provides investors with transparency and governance over the assets being traded.
Defactor connects to DeFi Liquidity Pools (LPs) via Centrifuge. The native token of Defactor, $FACTR, is built on the Ethereum protocol. Collateral Assets provided are tokenised on the Defactor platform as Non-Fungible Tokens (NFTs) on Ethereum or Centrifuge’s Altair chain for NFTs to be funded via Centrifuge.
Defactor is building a set of LPs on their platform and on the Algorand blockchain with a grant received from the Algorand Foundation. Their mission is to accelerate the adoption of DeFi to become a true competitor in the financial services market and decrease the barriers of entry for SMEs and developing countries, allowing them to access alternative sources of credit.
Conclusion: Opportunities for the future
Distributed Ledger Technologies (DLT) such as blockchain can play an important role in digitising traditional documentary credit as well as supply chain finance. The use of real world assets in mutually trusted, legally recognised and adjudicatable digital forms can improve global liquidity for individuals, private companies, governments and societies at a time of high inflation, high levels of debt and shrinking economies. Some of the benefits of DLT technologies are:
- Creating trust between parties that do not know each other as well as trust in data and documentation. Applied to trade finance, DLT based technologies such as blockchain can enable trust in digital documents by certifying their provenance and correctness.
- Digital identification of trade (finance) stakeholders and thus address KYC compliance.
- Expand access to carriers, freight forwarders and brokers, and other supply chain agents by improving trust in digital trade and trade finance transactions.
- Smart contracts that could be applied to automate trade logistics and payment processes.
- Reduce the quantity of rejected financing proposals by improving data availability and enabling a track record of trade transactions.
By reducing entry barriers, providing access to liquidity and capital, DeFi gives higher visibility and transparency for every step of the trade process. In reality, DeFi is a low-risk, secure solution with huge potential to fill the persistent growing $1.7TRN per annum trade finance gap between supply and demand in the trade finance market.
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