A new kid on the block: DeFi and Trade Finance

Insights Articles | 06 April 2022

A look at how DeFi is driving digital transformation of financial services and the role it is increasingly playing in more traditional financing such as trade finance. In collaboration with Valk Technologies www.valktech.io

DeFi, or decentralised finance, represents an innovation driving the digital transformation of financial services. The technology behind this innovation is based on secure distributed ledgers, like those used by cryptocurrencies such as Bitcoin and Ethereum.

Whether savings accounts, lending/borrowing facilities, asset management or even more complex products, these financial instruments are provided through a peer-to-peer framework without an intermediary such as a bank or broker. This has opened access to these products worldwide. The only requirements are an internet connection and a digital wallet (such as MetaMask) that can run on the blockchain, primarily Ethereum. There is a broad range of wallets available like Avalanche, Solana and Binance Smart Chain, to name a few.

These blockchains and the services they provide run on smart contracts, which are self-executing contracts written in code, with the terms of the agreement explicitly written and stored across the distributed network.

Trade finance represents the financial instruments and products companies use to facilitate international trade and commerce.

  • Trade finance makes it easier for importers and exporters to transact trade business.
  • Trade finance can help reduce the risk associated with global trade by reconciling the divergent needs of an exporter and importer.
  • “Some 80 to 90 per cent of world trade relies on trade finance (trade credit and insurance/guarantees), mostly of a short-term nature.” — WTO

Trade finance provides the exporter with receivables or payments based on the agreement that the importer might be extended credit for the trade order. The 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. 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.

trade finance gap causes

Bridging the gap between DeFi and Trade Finance

  1. For trade finance, decentralising the various components means that many services (verification, risk assessment, collateral valuations) currently undertaken by a few centralised banks in the traditional financial sector can instead involve distributed coordinated elements to secure the network efficiently.
  2. The decentralised and peer-to-peer approach to validation allows digitised rather than paper-based workflows and reduces the costly and time-heavy process behind transactions.
  3. This ultimately will result in reduced entry barriers, more accessible access to liquidity and capital and lower dependence on intermediaries and more dominant parties.

How DeFi can address these Trade Finance Gap problems

  • Minimal capital: DeFi can open financing solutions across the globe. It does not discriminate against borrowers and allows access to non-bank capital from DeFi lending pools.
  • Document verification problems: DeFi allows for digitisation of processes, including KYC, AML, document uploading and other workflows
  • The insufficient size of transactions: DeFi pools debt capital from lending pools all over the world, aggregating the capital and deploying it efficiently
  • Firm related high level of risk: unlike in traditional finance, where a borrower’s creditworthiness is evaluated based on their capability to pay the loan back/their previous performance (credit score), DeFi allows the borrower to collateralise illiquid assets. These tokenised assets can be provided as collateral and encoded within the smart contract for the collateral to be seized by the counterparty in the event of a default. Often, the collateral is worth more than the loan to reduce the risk to the lender. Thus, instead of traditional, predatory, and often unfair terms that may exclude many potential borrowers from trade finance, efficient ways to tokenise collateral within the smart contract can bring otherwise illiquid assets (such as receivables, invoices etc.) into the agreement and allow more borrowers into the ecosystem.

Additionally, any data and financial information are securely shared across parties within a smart contract on the blockchain, replacing the analogue letter of credit, giving higher visibility and transparency for every step along the trade process.

Other Benefits of DeFi

  1. Expands access to asset financing: going bank less lowers the barrier of entry for originating and investing in assets
  2. Scales asset financing: lending pools can grow very big and create liquid marketplaces for illiquid assets, unlocking the value of these assets that can be leveraged as collateral for financing
  3. Bridging Traditional Finance (TradFi) and DeFi: Creates a bridge between the liquidity from DeFi liquidity pools and tangible assets from the TraFi world

The Impact of Financial Disintermediation and DeFi, or cutting out the middleman

The recent rise in technological innovations has paved the way for disintermediation in the financial sector. Decentralised Finance, or DeFi, has promised a future of financial services occurring without intermediaries, reducing transaction costs, and increasing efficiency as agents. This arguably has been a trend before the emergence of DeFi, as FinTech companies in the last decade took more and more market share away from the traditional financial sector by offering specialised services related to micropayments, P2P loans, savings/investments and more.

DeFi has taken this further and provides financial services (lending, borrowing, saving, insurance, derivatives, asset management) on blockchains like Ethereum, Solana and Avalanche. These blockchains allow applications (or dApps, decentralised Apps) to be built on top, hardcoded using smart contracts to leverage distributed ledger technology to validate transactions, transfer ownership of assets and economic logic without the need for centralised intermediaries. This enables anyone to participate in these financial services all over the world. Nearly $200 bn of crypto assets are currently locked up in protocols across layer one blockchains (Ethereum, Avalanche, Solana, and others). Each protocol has its offering; some, like Aave and Compound, are simple borrowing/lending applications. Users can deposit their crypto assets into a lending pool to earn interest or borrow holdings using the aforementioned collateralisation mechanism. Other protocols involve more complex financial actions such as staking, swapping, trading, etc. For example, Uniswap, a decentralised exchange, allows users to swap one Ethereum-based crypto asset for another, with other parties acting as liquidity providers for the exchange and receiving a share of the fees in return.

Finally, blockchains have allowed the connectedness of money globally, meaning that wealth transfers can occur worldwide with minimal costs and transaction time. For example, the transaction fee for Bitcoin has remained chiefly below $5 for the past six months, with layer two solutions such as Lightning network bringing it below $0.05 and other networks such as Ripple with almost zero fees. This way, money can be standardised through cryptocurrencies or stable digital coins, eliminating the need to use costly exchange rates or cross border operators such as Western Union.

MakerDAO: Bridging TradFi and DeFi

Several firms have started to bridge TradFi and DeFi, such as Centrifuge or MakerDAO. The latter has stuck to its commitment to connecting assets from traditional finance with the liquidity in DeFi. In late 2021 announced that it wanted to onboard $300M worth of Real-World Assets as collateral DAI. These assets can represent tokenised debt, real estate, factoring invoices, etc. One notable example was refinancing covered bonds back by home loans, issued by Societe Generale and tokenised onto the Ethereum blockchain, with the credit equal to 20M DAI. More significantly, it has developed the Arranger Model. Its community (who govern the DAO, or Decentralised Autonomous Organisation) selectively assess collateral onboarding applications proposed by financial institutions who wish to bring assets on the chain to be financed by MakerDAO’s Real World Finance Unit. The arranger model is designed so that asset originators can provide a scalable framework that can be assessed, valued and structured efficiently without draining the DAO’s resources.

VALK

More recently, leading tokenisation platform VALK has developed an efficient framework within Maker’s Arranger Model. VALK has been tokenising financial assets (equity, debt, or a mixture of the two) belonging to 100+ clients (all regulated financial institutions) onto its platform using the Corda blockchain. However, it has also been building on top of blockchains such as Ethereum and Avalanche. Through its mission to digitise and decentralise private capital markets, it has been structuring and streamlining a model that applies best for Trade Finance, intending to ultimately bridge the financing needs of the $5 bn assets live on its platform with the vast liquidity present on-chain. By using the technological capacity for tokenising investments onto the blockchain that it has developed over the last two years, VALK is tokenising any marketable security on-chain for it to be used as collateral to draw down financing from major lending pools.

VALK’s Aggregator

VALK is building DeFi products to facilitate the onboarding of institutions into DeFi. These include Merlin, a DeFi smart wallet that tracks and monitors positions within a portfolio, reporting daily profit/loss, yield, NAV and more to assist with accounting purposes necessary for institutions to run large portfolios across protocols. VALK is also building an aggregator to act as a portfolio management system (PMS). Using the PMS, digital asset managers/funds can manage all positions in one interface. VALK’s interface acts as an API for all protocols, connecting financial institutions interested in digital assets to major DeFi protocols. By building connectors to the most popular protocols, the aggregator allows investors to get all functionalities (deposit, withdrawals, lending, borrowing) related to different protocols without leaving our interface.

VDeFi DeFi to TradFi Pools

On top of general and complex DeFi strategies provided on the PMS, VDeFi will integrate TradFi to DeFi pools onto the intelligent account. This way, accredited investors (those who pass compliance checks such as KYC and AML) can directly provide liquidity into these pools (such as Trade Finance assets) directly from the VDeFi interface. This will be an effective and exciting way to onboard institutional investors into DeFi whilst bringing assets from TradFi on-chain.