Why Blockchain is not the end of Trade Credit Insurance
By: Niclas Aunin
Tags: Trade, Trade Credit Insurance, Insurance, Crypt, Blockchain

Blockchain is one of the most hyped technologies right now and many people acknowledge the huge disruptive potential blockchain has, especially for changing the banking, financing and insurance industry fundamentally. Most of its potential arrives from the promise of a decentralised, distributed and immutable ledger that replaces intermediaries by enabling transactions between two entities that do not trust each other.

At first sight, blockchain seems to be in a good position to make trade credit insurance (TCI) redundant, given the fact that TCI is traditionally acting as an intermediary between buyer and supplier by insuring the suppler against the non-payment of B2B trade receivables and, therefore, providing credit risk information.

But with a second thought and despite the huge disruptive potential for the finance and insurance sector — and trade credit insurance combining both aspects — there are clear indications that a blockchain will not be able to make TCI redundant — mainly because the technology solves a different problem.

Here’s why:

The blockchain technology was created as a peer-to-peer electronic cash system to enable two anonymous parties without a relationship of trust to exchange value represented for instance by a cryptocurrency coin or a token by storing their transactions on an immutable, distributed ledger and without the intermediary interaction of a financial institution.

This is all the blockchain background knowledge you need for now to catch the following text. (If you are familiar with the concept of trade credit insurance, you may skip the next paragraph)

TCI covers businesses’ accounts receivables against non-payment. For example if a supplier sells goods to a buyer on credit terms, e.g. 60 days before the invoice is due. If the buyer fails to pay the invoice on time, the supplier automatically has a claim against the credit insurer by the insured amount of trade. This kind of payment terms are common in B2B trade and are a comparably cheap financing option for the buyer. Therefore, the risk evolves from the seller being unable to predict, if the buyer will be able to pay in the future. Credit insurers can carry the risk arising from the uncertainty to be payed.

Therefore, TCI solves the problem of not being able to ensure that a buyer will pay receivables in time to a supplier in the future, while the supplier needs to offer payment terms to stay competitive by allowing the buyer more flexibility to pay and to fund the invoices.

Blockchain would just need to solve one of the problems, as they are dependent on each other. Given there would be no risk associated with guaranteeing credit terms, TCI would be redundant, as there is no demand on the supplier side. Alternatively, if buyers do not demand credit terms because they have more favourable financing options, suppliers do not need TCI.

Let us analyse how blockchain could be applied to this problems — and where it fails:

Can a blockchain ensure that a payment will be made at a specific date in the future?

You may have heard of smart contracts: self-executing contracts, written into lines of code to exchange value based on predefined events, stored and monitored on the blockchain. According to some blockchain enthusiasts, smart contracts are the “holy grail” of the blockchain. They verify that all stakeholders in a transaction, have the resources available to execute a trade transaction and trigger further transactions, based on events that are tracked on the blockchain.

The smart contract can for example check that someone owns enough bitcoins to trade them for a specific amount of another cryptocurrency or good, represented on the blockchain as a token. You can also code a smart contract to make a payment with some delay or after a defined event happened, e.g. after an event on the blockchain confirmed that shipped goods arrived at the buyer’s location.

However, when the smart contracts triggers the payment and a buyer does not own enough money or assets, which can be transferred to the supplier’s account, the payment cannot proceed.

The smart contract might now transfer ownership of certain goods back to the seller, but in reality it is often not possible to recover the full value of the delivered goods, resulting in the supplier still making a loss as:

· the buyer has already sold the products within the payment period and is now bankrupt,

· the products lost value (e.g. perishable goods),

· or can’t be reversed (like all services).

Logically, one could now argue that a smart contract could lock the specific amount of money in on one’s account (or wallet, a storage for cryptographic assets) and then proceed with the payment once the payment is due. However, this would eliminate the finance function of the payment terms, as the Buyer will not be able to use his funds for other purposes in the meantime, as he can’t double spend his money, neither in real-life nor on the blockchain.

As a conclusion, smart contracts are not able to ensure that a payment will be made at a specific date in future. If the funds or goods to be transferred are not available, the smart contract is powerless. In very simple terms, the problem that trade credit insurance solves still exist in a blockchain world:

No money — no funny.

But what if we are able to completely remove the need to use payment terms as a financing tool?

There are two options how blockchain might achieve this: either by significantly increasing the market power of suppliers (or respectively decreasing market power of buyers), enabling them to negotiate contracts without payment terms or by providing more favourable financing options, so that buyers do not demand payment terms.

(Obviously, there are several other good reasons to trade on payment terms, e.g. when it comes to disputes, pending payments during shipping and complex pay out processes corporates. In some of these areas, blockchain actually might be a solution, but the general problem would still exist, even if you solve these particular cases.)

I am not aware of any approaches or ideas regarding significant increases of supplier’s market power, so maybe my research was not detailed enough, but most likely it’s because this problem is different from the one blockchain is trying to solve, as blockchain is about trust, not about power.

For the second option described above, it is slightly different. There are currently many publications on use cases and proof-of-concepts in the finance, banking and lending space, such as peer-to-peer lending and further alternative sources for financing and funding finance, which promise reduced overhead costs due to more efficient processes on the blockchain. However, just because lending happens on a blockchain, does not mean it is “free money” for debtors.

While there are valid use cases and proof of concepts in the financing field, which demonstrate how the use of blockchain could help to reduce settlement costs, improve risk insights and mitigate fraud, similar results can be drawn to trade credit insurance as well.

Most importantly however is, based on simple financial markets theory, that investors and lenders in capital markets expect a return on their investments that adequately pays off for the risk the investors take in their investment. Therefore, while there is a risk associated with giving financial flexibility to a company, either via financing solutions such as lending, or by offering payment terms, there will be a price tag on it and companies may want to mitigate this risk.

Beside these fundamental challenges that blockchain is currently facing and before coming to my conclusion, I would like to highlight further general challenges, that are not directly related to TCI, but help to understand why blockchain is still far away from mainstream adaption:

· Many open questions regarding a regulatory framework.

· Smart contracts are only as efficient as the underlying code (usually written by a human person!).

· Ensuring physical goods represented by tokens on a blockchain exist in reality.

All in all, given the current abilities of blockchain technology and the outlook what advanced blockchain solutions, that are currently being developed, aim to solve, the blockchain technology cannot solve either of the two fundamental problems for which TCI provides a solution:

1. Ensuring that payments will be made at a specific date in the future.

2. Making payment terms as a financing tool in B2B trade redundant.