Free for all?

Feature | 28 March 2017

Trade digitisation platforms are being developed at an unprecedented rate but with little or no consideration for how compliant they are with the regulatory demands on banks, says Geoffrey Wynne

There is no doubt that recent years have seen an increase in available technologies to be used in areas such as trade finance.

Those promoting techniques such as blockchain and distributable ledgers say that their use will speed up trade flows. They also argue that the technology is secure and there is no need to worry about issues such as forgery or fraud. Speedy transmission of key information has many advantages for sellers of goods, the main one being that they can be paid more quickly as the purchaser receives instantaneous information on which to settle invoices.

It is then possible to trade receivables created by these transactions more easily as the information required in order to establish a party's liability is also available more quickly. Thus, overall complexity and costs are potentially reduced while increasing access to information for new customers.

Have law and regulation caught up?

Law and regulation may not yet have caught up with the acceleration of fast moving information.

It is often not clear who takes responsibility for 'wrong' information or for the fraudulent use of information. Parties to a transaction are free to negotiate the allocation of risk and contract accordingly. However, where those parties, as well as previous and subsequent parties, are each relying on information processed by another party (the distributable ledger) and this information proves to be wrong, who bears that risk? Does the principle of caveat emptor (buyer beware) still apply?

Despite the potential benefits of having an increasingly electronic world, uncertainties remain. For example, how can someone verify all they need to know about the parties to a transaction? Can they be certain that nothing in the transaction breaches any sanctions? Are the proceeds being used to launder money or for financial crime or terrorism? Mercuria v Citigroup [2015] (the Qingdao case regarding warehouse receipts in China) is a recent case which demonstrates the danger of over-reliance on e-documents, without the maintenance of efficient safeguards.

Saying that this could happen under non-electronic solutions is not an answer, even if true.

A better and more certain way of verifying information is needed and solutions for the centralisation of information for the good of all are being offered by, for example, by SWIFT. It is perhaps ironic therefore, that at the same time, a tightening up of data protection laws in the EU in the form of the General Data Protection Regulation (which comes into effect in May 2018) may make it easier for the unscrupulous to avoid detection. It is yet to be seen how exactly this regulation will work with systems facilitating the centralisation and accessibility of data.

The use of e-documents

E-documents are not new in trade finance. SWIFT has existed for many years, allowing transactions to be processed electronically. The ICC promulgated e-letters of credit alongside the rules set out in UCP 600 (Uniform Customs and Practice for Documentary Credits). In addition, the BPO (bank payment obligation) (under URBPO jointly drafted by SWIFT and the ICC) allowed for payments to be made between banks based on matching data. The fact that take-up has been slower than expected is testimony to concerns that exist in financial institutions of both known and unknown risks. In some ways, the slow up-take is strange, as matching data is precise, whereas human checking can miss breaches of compliance or indeed fail to spot non-compliant documents.

The current system is not fool proof, as shown by recent litigation on discrepancies in letters of credit. The current position is that a court is the ultimate arbiter of a dispute between a confirming bank and an issuing bank on whether or not a presentation under a letter of credit is compliant. Would an electronic system tolerate minor discrepancies and allow trade to proceed? Flexibility is crucial, as it is important that trade is not hindered by technical advances.

In some ways, the key to progression lies with those companies who promulgate electronic solutions. Instead of arguing that their systems are totally secure, they should look at their user agreements and see what parties are being asked to sign up to. It is clear that a system which provides information must guarantee its authenticity. At this point the platform provider or equivalent must take that 'guarantee', check it and then accept responsibility to those future users of the information. The question as to whether that guarantee is insured by the market is up to the users to agree.

Where does regulation fit in?

The regulators need to look at current regulations in light of these fintech advances. Banks that are regulated need to know that how they deal with information received electronically will be taken account of in assessing compliance with sanctions, KYC (know your customer), AML (anti-money laundering) and financial crime avoidance requirements. There are a number of companies offering electronic solutions in these areas.

Regulators must state that they accept compliance has been satisfied where a financial institution puts in place a technical solution that has been accepted by the regulator. Ideally such a solution should have the equivalent of a 'kite mark' indicating it is acceptable to the regulator. Once this is achieved, the speed of transactions and the approval process will itself increase and become simpler.

It is interesting that the law may be falling behind the electronic advances. Historically, documents were physically signed. It was not unusual to have parties present in a room to sign. Often, a notary was there to authenticate the individual, the signature, or both. Today, this seldom happens. Sometimes, a PDF of a signed page is relied upon. Can electronic signatures be relied on?

The Electronic Identification Regulation came into effect on 1 July 2016. In the UK, the Law Society provided a practice note on the use of electronic signatures - a piece of non-binding guidance. The whole regime for electronic signatures is now complicated by requirements to have trust service providers to verify electronic signatures. English law has made the execution of deeds complicated as a result of the Mercury case (R (on the application of Mercury Tax Group and another) v HMRC [2008]).

The Law Society note flies in the face of acts like the Bills of Exchange Act 1882. Perhaps a new law will be necessary to clarify important points such as the execution of bills of exchange and promissory notes. These are key instruments evidencing payment obligations. They are often the backbone of many trade and forfaiting transactions. The enforceability of these is key to a vibrant secondary trading market.

Stuttering promise of blockchain

Blockchain is often defined as a database operating through distributed ledger technology (DLT). DLT is an online ledger which allows two or more entities who do not necessarily know each other to agree something is true without the need for a third party to certify ownership and/or clear transactions. This means that users must pre-agree how to deal with information. Information is placed into a 'block' which is then 'chained' to the next block. It is arguably safer to use this method for anyone with permission to do so.

Some blockchain properties lend themselves well to trade finance programmes. Thus, they can be used to demonstrate the existence of goods, streamline settlement of sales and allow transfer of ownership. Smart contracts which exist only electronically can be executed automatically once certain conditions are satisfied.

This can lead to an automated supply chain with logistics and management happening automatically. Arguably, the ledger can be verified. It can be searchable and consequently effective monitoring can be carried out in all areas of compliance for the benefit of the participants and their regulators. The issue to be resolved remains - who ultimately takes responsibility for the verification of the information so that multiple transactions can take place using the technology?

Interesting technical issues remain to be resolved where transactions are carried out on multiple platforms. Will they 'talk' to each other? Can verified information be transferred across platforms? Experts say all this can, and does, happen. The legal framework may lag behind, and indeed, the user arrangements may ignore some of the issues.

Current and future providers

Companies and financial institutions have been selling technology solutions since the 1990s. Every so often a new provider emerges. The question is whether the established providers can maintain their position or whether a new provider might take the market by storm. How big is this market, both actual and potential?

There are times when a new solution arises with huge potential, only not to fulfil that potential, at least not in the immediate term. There can be many reasons for this. Sometimes, users themselves are reluctant to change their practices but often it is because the legal framework in which that technology is to operate has not been explored fully. Thus, a solution
to a problem that itself creates problems is
not helpful.

In some cases, a solution, especially in the compliance context, looks to be very helpful but is not taken up. This can often be because the regulator will not be prepared to support it. Perhaps there should be a forum where providers, users, regulators and legal advisers get together to solve the problems. It is surprising that existing suppliers do not take advantage of their position in the market to do this. If they fail to do so, then perhaps the new providers might supplant them.

In reality, the future is bright for technology. It has an inevitability about it. This must be good if the delivery of so-called solutions can have a sound basis in both law and regulation.

Geoffrey Wynne is a partner at Sullivan & Worcester and head of the firm's trade and export finance practice

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