The Value of Smart Contract in Trade Finance

Author Information:

Fasheng Xu, Whitman School of Management, Syracuse University
Xiaoyu Wang, John M. Olin Business School, Washington University in St. Louis
Year of Publication : Manufacturing & Service Operations Management (2022)

Summary of Findings:

We find that the value of smart contract depends critically on the trade finance structures, including both pre-shipment and post-shipment financing schemes.

Research Questions:

We explore how the adoption of smart contract can affect the incentives of supply chain members and whether and how its anticipated benefits may be realized under different trade finance structures. To do so, we propose a supply chain finance model where the capital-constrained supplier is in need of both pre-shipment financing and post-shipment financing, and examine how the adoption of smart contract affects the supply chain operations and profits.

What we know:

As the emerging blockchain technology could potentially reshape the trade financing landscape, understanding the impact of smart contract adoption and its interaction with trade finance activities is practically relevant and of great importance

Novel Findings:

Our main contribution is to propose a general supply chain finance model framework that enables us to quantify the value of smart contract when different types of trade finance instruments are in place. Our theory can help ``debias" the value of smart contract (as might be incorrectly promoted by many FinTech firms) and promote more legitimate implementations of this technology in the trade finance domain (or more broadly, the supply chain area). Caution is warranted if one merely considers the direct positive impact of smart contract (e.g., allow creditable commitments that previously would be expensive to enforce), but largely overlooks its indirect effect on supply chain firms' incentives as well as their strategic choice of different trade financing schemes.

Implications for Practice:

The increased attention to blockchain-related technologies and emerging application scenarios (e.g., DeFi: decentralized finance, NFT: non-fungible token, Web 3.0, etc.) has brought smart contract into sharper focus. A central premise of smart contracts (and more broadly blockchain technology) has been that the automated algorithmic execution based on mapping states of the world to corresponding contractual actions, which can create creditable commitments that previously would be expensive or impossible to enforce. In our analysis, we investigate to what extend smart contract indeed allows for this premise to be realized in the trade finance domain; we find that while smart contracts can indeed mitigate the commitment frictions, in many cases the ability to add value to the supply chain critically depends on the underlining trade finance structures.

Implications on Research:

The paper makes three main contributions. The first is to provide a general supply chain finance modeling framework to examine trade finance activities at both pre-shipment and post-shipment stages, whereas the extant supply chain finance literature has so far focused almost exclusively on pre-shipment financing. As such, we are able to generate novel insights regarding the interaction between pre-shipment and post-shipment financing schemes. The second is to show that the decision to adopt smart contract should depend on specific trade finance situations. Smart contract is not a ``cure" for all business settings. For example, when the retailer's direct financing is available, smart contract adoption might reduce the supply chain profit. The third is to quantify the value of invoice trading that enables speed-up transaction process and real-time financing offering. Despite its importance (and widespread adoption), invoice trading has received little attention in the literature.

Full Citations:

Wang, X. and Xu, F., 2022. The Value of Smart Contract in Trade Finance, Manufacturing & Service Operations Management (Forthcoming)

Abstract:

Problem Definition: Smart contract improves the supply chain efficiency by enabling the supplier’s commitment to post-shipment financing decisions, which mitigates the bank’s lending risk exposure and thereby reduces the financing cost. This paper investigates how smart contract adoption could facilitate trade finance activities and create value for supply chain firms.

Academic/Practical Relevance:

As the emerging blockchain technology could potentially reshape the trade financing landscape, understanding the impact of smart contract adoption and its interaction with trade finance activities is practically relevant and of great importance.

Methodology:

We develop a two-stage game-theoretic model and adopt supply chain finance theory to characterize the strategic interactions between supply chain firms in the presence of both operational risk (demand uncertainty) and financial risks (credit and liquidity risks).

Results:

We find that the value of smart contract depends critically on the trade finance structures, including both pre-shipment and post-shipment financing schemes. Under the baseline trade finance model (with purchase order financing as pre-shipment financing and factoring as post-shipment financing), smart contract alleviates the supplier’s overpricing behavior caused by commitment frictions and helps restore the supply chain efficiency. When buyer direct financing serves as an alternative pre-shipment financing, smart contract might discourage the retailer from offering buyer direct financing, which significantly hurts the supplier and thus reduces the supply chain profit. When invoice trading serves as the alternative post-shipment financing, the supplier always chooses invoice trading over factoring due to its trading flexibility which, in turn, makes the commitment frictions ubiquitous and unresolvable (namely, commitment trap). As a result, invoice trading could unexpectedly lead to a lower supplier’s profit. Luckily, such an adoption dilemma can be resolved by smart contract adoption in conjunction with factoring.

Managerial Implications:

Our findings provide guidelines for and insights into when smart contract should be adopted and its interactions with different trade finance schemes. In particular, smart contract adoption does not always benefit the supply chain.

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