Looking Ahead: Global Trade and Finance 3.0 – Towards a (Digital) Rules-Based System

30.10.2020 Ed Macgregor
Looking Ahead: Global Trade and Finance 3.0 – Towards a (Digital) Rules-Based System

Trade is crucial to the recovery from COVID-19, but in a more complicated political, economic and security environment. It is critical to “build back better”, and to build a standardised, digitised and connected ecosystem that covers both trade and trade finance, that allows for the streamlined introduction of new participants (including new suppliers of capital in trade finance) and which reduces the time, risk and cost of trade. While there are a number of current initiatives to digitise trade, or trade finance, there is the need for an integrated solution that brings the best of business, knowledge and government together, and which further leverages the developments in technology, trade and new sources of capital and funding.

 

The challenge and the opportunity

This year has fundamentally changed the way organisations approach trade across borders, and finance that trade. Although trading dynamics are naturally influenced by major global events and market cycles, the past 12 to 18 months in world trade is demonstrating ‘special characteristics’, shaped by:

  • geopolitical risk and tensions, crystallising the interconnected nature of diplomacy, security, trade and economic policy
  • macro shocks, including the health, social and economic impacts of Covid-19 and the exposure of fault lines in global supply chains
  • reverberating disturbances in domestic markets and volatility in economic and conditions
  • the reduction in the number of providers of trade finance in the markets, and the amount of credit available from those continuing to provide it; and
  • the emergence of ‘economic nationalism’ in domestic regulatory and trade policy, with tightened controls on inbound trade and investment and specific exportations.

As trading across borders becomes more complex, the focus of market participants is on the cost of doing business across borders. Many are strategically assessing the long-term value of establishing and maintaining cross-border commercial relationships, investing in and funding the operation of offshore assets and the risk-weighted commercial returns of their global activities. Simultaneously, the pendulum of commercial strategy has swung from a focus on the efficiency of global supply chains – and their component assets and associated cash flows – to efficiency and resilience, security and sustainability.

These themes bring the objectives of the WTO Trade Facilitation Agreement – entering its third year of implementation – into sharp relief. In a global system characterised by heightened volatility and risk, the removal of unnecessary red tape has never been more critical to maintaining the stability of global markets and the flow of global trade, commerce and finance through them.

Meaningful change requires a meaningful rethink of the approach to the fundamental units of the system; the flow of contracts, instruments and other forms of ‘paper’ that establish relationships, fund trade and investment and intersect with domestic legal and regulatory frameworks. This will require connected and cooperative engagement between business and government, and a strategic approach to implementation across local, regional and global trade and investment channels.

The paper trail of global trade and finance

The market tumult caused by COVID-19 has emphasised the commercial, legal and regulatory challenges with managing the traditionally ‘analogue’ model of global commerce that relies on the ability to distribute parcels of physical documents (or electronic versions of physical originals), often containing similar or duplicated information, transmitted between counterparties, financiers, intermediaries and regulators.

Less obviously, but possibly more importantly, it has highlighted more nuanced problems linked to the ‘hybrid’ environment that many market participants operate in – a mix of digital documents, electronic versions and, in many cases, forms of physical paper with ‘wet’ ink and official stamping requirements.

Even in normally functioning markets, this dynamic puts ‘sand in the gears’ of global commerce. In wake of COVID-19 and the sharp transition to a largely virtual trading environment, this sand has the potential to solidify at key commercial touch points and cause substantial commercial and legal risk to business.

The volume, variety and velocity of documentation generated in connection with global trade, finance and investment flows has increased in lock step with the pace of regional and global economic integration, direct and indirect investment, the rapid growth of digital trade and e-commerce and the multi-tiered structure of physical and financial supply chains. Organisations involved in cross-border commerce sit on top of a complex mosaic of rules, rights and obligations contained in a broad universe of documents in structured and un-structured formats. For most organisations, this contract ‘stack’ is simultaneously its greatest commercial asset and its most significant source of risk and potential liability, which is further complicated now by the mix of physical, electronic and digital paper.

The notion of resilience – the ability of an organisation to recover from severe disruptions – has featured as a key policy concern of global business leaders over the past three years, but has become ubiquitous in corporate strategy narratives over the past six months. While typically framed in terms of business systems, structures and corporate programs, it applies equally to the commercial contracts and commercial rules that are the blueprint for the performance (or non-performance) of operating assets, cashflows, supply chains and financing programs.

Contracts in context – market impacts on the contract ‘stack’

The impact of Covid-19 has highlighted three significant economic and commercial realities:

  1. Global commerce is more complex than many appreciate;
  2. The operation of markets, corporate activities and legal rights are interconnected; and
  3. There is a legal foundation to all business activities and corporate strategy

A natural consequence of a major market shock is that the ability of market participants to comply with their obligations under the layers of agreements that define their operating models is constrained, or temporarily or permanently restricted.

Many organisations have, first reactively and then proactively, examined the degree of ‘flex’ in the four corners of their commercial contracts to provide forbearance or ‘holidays’ on specific obligations that would otherwise result in default, and negotiate different approaches to managing their commercial relationships, and the mesh of their commercial agreements, in order to protect the flow of goods and cash

The complexity and risk of this dynamic is amplified in volatile market conditions as external events may cause contracts to operate in a particular way, to allow parties to do, or not do, certain things and, in extreme cases, impact the validity or enforceability of the contract. The nexus is particularly pertinent in relation to contracts that govern cross-border transactions. The factors in these contracts that relate to the quantity, timing, form, price and terms of supply, and the financing arrangements that are connected to cash flows, can be dramatically influenced by events that occur across the chain of global transportation, handling and custody and regulatory treatment. Errors in the ‘flow’ of contracts enabling cross border transactions can lead to substantial delays in the physical chain of supply and the financing that supports them. Similarly, external events that disrupt the physical supply chain impact the operation of key contracts. Both scenarios can potentially trigger a cascade of obligations that may result in the aggregation of significant penalty fees and costs and, in the extreme case, jeopardise the operation of commercial and financial arrangements.

Structuring for consensus

There are several common challenges to this type of ‘adaptive’ management of commercial contracts in cross-border trade, including:

  • Identification – mapping the contracts, instruments and agreements that support cash flows, capital and financing, and the supply chain itself;
  • Interpretation – defining the nature of rights and obligations with suppliers, intermediaries, customers and creditors;
  • Risk and mitigation – modelling the relationships which if they were to be temporarily or permanently impeded, would the biggest impact on commercial and financial programmes and alternative ways to manage the performance of these contracts.

Ambiguity, inconsistency and the lack of standardisation in common business contracts adds an overall ‘drag’ factor to these processes in relation to an organisations’ ‘back book’ of commercial contracts, and potentially perpetuates barriers to capturing the commercial value of transitioning to digital contracting models.

Defining and adopting a commercially-oriented, rules-based approach to contracting can lead business to use documents that most effectively establish and manage trade, commerce and finance – providing tangible benefits across the lifecycle of commercial contracting, including:

  • Construction - shaping the way contracts are constructed (including through the use of automated authoring and conditional reasoning to minimise the use of terms that can give rise to interpretive uncertainty);
  • Negotiation - streamlining the negotiation of contracts by rationalising the category of terms and concepts that require specific drafting;
  • Operation - reducing operative contractual obligations between counterparties to commonly understood mechanisms that can be adjusted as needed and, potentially, expressed in computational language to enable electronic execution;
  • Management - enabling the technology assisted management of contracts over their lifecycle by creating definitive links between key terms and external trigger events occurring in the ‘real world’; and
  • Understanding - last, but certainly not least, establishing common rules and terms for contracts, that allow contracts to be understood and used by their business stakeholders without the need for translation by the lawyers.

A system of rules in the rules-based system

This transition to standardisation and paperless digital trade and finance requires both the push of business through the adoption of different modes of contracting and the pull of governments, effective domestic policy and the joint development of common and interoperable digital standards, rules and technologies.

While there is a significant amount of ongoing work, the academic, policy and regulatory landscape that applies to the facilitation and governance of digital commerce and finance is complex. This global patchwork includes:

  • agreements specifically focused on trade facilitation, simplification and paperless trade, including the WTO Trade Facilitation Agreement and the UNESCAP Framework Agreement on Facilitation of Cross-border Paperless Trade in Asia and the Pacific;
  • bi-lateral and multi-lateral agreements focused specifically on the development of frameworks and principles to facilitate digital commerce and access to the global digital economy, including the Digital Economy Partnership Agreement (DEPA) entered into by Chile, New Zealand, the Singapore and the Australia-Singapore Digital Economy Agreement (DEA) and, most recently, the Abu Dhabi Global Market (ADGM) Consultation on Electronic Transactions; and
  • e-commerce chapters in bilateral and plurilateral Free Trade Agreements relating to electronic instruments.

Additionally, consistency and standardisation within the global trading system is supported by the ongoing work of the UN Centre for Trade Facilitation and Electronic Business (UN/CEFACT) and the World Customs Organisation (WCO) with respect to the development of common data models, as well as the robust body of legal academic analysis exploring the practical application of Extensible Markup Language for digital contracts.

The aggregate of this means that the Rubicon has been crossed, as we move into the commercial proof of concepts in relation to computational (smart) contracting.

The Asian opportunity

Trade is core to economic and geopolitical networks across Asia, Australia’s role and engagement with Asia and will be part of the emergence from the COVID-19 environment. Documentary compliance requirements are a key cause of friction in the management of cross border trade into and within Asia. Common digital standards and interoperable technology infrastructure that enable transparent, secure and compliant engagement between commercial counterparties, intermediaries and Government agencies can and should play a major role in facilitating and removing barriers to international trade. In terms of the potential impact of improvement in these areas, recent UN modelling suggests that the digitisation of trade paperwork could enable export trade from Asia-Pacific countries to accelerate by US $257 billion a year.

The downward reforecast of Australian customs and excise duty of $2.3 billion for FY 2020-21 is a clear signal of the substantial impact that COVID-19 has had on Australia’s cross-border trade flows. The development of policy and the implementation of practical solutions to materially progress the modernisation of Australia’s trade system will be critical to overall economic recovery and accelerated growth. While the trading landscape in 2020 and beyond offers new challenges, the actions that should be taken to ensure that Australia makes the most of the opportunities of the digital economy, highlighted in the 2018 report of the Joint Standing Committee on Trade and Investment Growth inquiry in relation to trade and the digital economy continue is more urgent. In particular:

  • the need for a cohesive, whole of government approach;
  • the need to build digital awareness into Australia’s education system, including those already working;
  • the need to rebuild systems, designing processes from the ground up;
  • the need to build cyber resilience; and
  • the need to work closely with trading partners and multinational organisations.

A range of commitments included in the 2020 Federal Budget signal recognition of the connection between Australian trade and economic growth and renewed focus on enhancing Australia’s trading infrastructure. These include, in particular:

  • $1.5 billion in funding over the coming five years for the Modern Manufacturing Strategy. Focusing on the six national manufacturing priority areas of resources technology and critical minerals processing, food and beverage, medical products, recycling and clean energy, defence and space;
  • $107.2 million in funding to support Australia's supply chain resilience going forward will assist in identifying and rectifying supply chain vulnerability to allow business to seize opportunities to supply critical products through both domestic and global supply chains; and
  • $28.6 million to look at ways to simplify and modernise Australia's trade system to build the foundations of a long-awaited single trade window, a pilot program for streamlining services from Australian Border Force and the Department of Agriculture, Water and the Environment and an extension of the Australian Trusted Trader program.

The allocation of capital to support Australian industry and to streamline the architecture of Australia’s trade regulatory system is an essential component of the bridge to recovery from the economic impacts of COVID-19. While these commitments are positive directionally, significant further investment will be required to unlock the opportunity.

Additionally, the recently inked Australia-Singapore DEA is a positive example of bi-lateral recognition of the need to look at the dynamics of modern trade through a digital lens and cooperatively build (and in some aspects re-build) systems that facilitate trade flows. The key outcomes of this agreement provide a blueprint of critical areas of focus for bilateral and multilateral collaboration that will be required to create and capture opportunity for digital trade into and within Asia. Particularly, the agreement provides a framework for the development of common digital standards and rules in relation to:

  • The compatibility and interoperability of electronic transactions frameworks, including digital authentication and document execution that provide the foundations of paperless trading through a single window;
  • e-invoicing and e-payment frameworks that follow international protocols that are commonly understood and accepted;
  • the implementation of online payment systems which improve the digital trade experience, built in accordance internationally accepted protocols to establish trusted and secure payment ‘rails’;
  • cross-border data flows and location of computing facilities; and
  • open banking frameworks supported by Government collaboration with reg-tech and fin-tech enterprises to improve access to finance and streamline processes within trusted and secure ecosystems.

The DEA has the potential to establish a ‘gold standard’ framework of rules that will enable and enhance corridors of digital trade between Australia and Singapore, providing a useful use-case for broader adoption across the region. However, there is more work required to effectively engage the opportunities of the DEA, and similar agreements and policies. In particular, we need:

  • Cohesive public policy and commercial practice – connected dialogue and focused effort by industry, domestic regulatory bodies and global institutions to promote consistency in methodology and approach to the formation of digital standards and rules, and more active efforts to align the approach to common commercial issues and opportunities;
  • Increased private / public collaboration on trade technology – structured and focused engagement between Government and private sector partners (with matched funding models) to advance research and development of digital trade initiatives and trade technologies;
  • Structured approaches to develop digital skills – the implementation of policy and practical initiatives designed to develop core competencies within the private and public sector (including those currently employed and those entering the workforce) in the use of technology to support international engagement and trading activities;
  • Embedding digital trade within trade and investment agreements – Free Trade Agreements, Bilateral Investment Treaties and similar agreements between Asian trading partners should include specific commitments in relation to the facilitation of trade transacted via e-commerce channels including the free movement of goods and differentiated customs procedures and to identify and adopt differentiated regulatory arrangements that will support the widespread use of digital contracts. The framework for implementation of the Regional Comprehensive Economic Partnership (RCEP) may provide a practical mechanism to advance these objectives;
  • Infrastructure and systems – engagement between Government, market participants and technology enterprises focused on the practical application of digital transaction management (including commercial contracting and regulatory compliance), with a reliable assessment of the commercial and economic benefits of digital commerce and finance; and
  • Focus on finance to close the trade finance gap - greater connectivity and interaction between technology providers, financial institutions, non-bank lenders and traders (including large entities, SMEs and MSMEs) particularly in relation to the opportunities to adopt digital systems and digitised rules to improve access to trade and supply chain finance.

From theory to practical application

There is precedent for this kind of system-scale adoption of rules-based models, although in a different industry. In 1992 (with updates made in 2002), the International Swaps and Derivatives Association (ISDA) published the ISDA Master Agreement, which effectively standardised the core terms of the contracts under which derivatives were documented and traded on a global basis. Additionally, over the past three years, in parallel with rapid advances in the practical application of process automation and digital contracting methods, ISDA has published a published several whitepapers and a series of specific guidelines outlining technical frameworks to support the creation and use of smart derivatives contracts. This includes guidelines for representing key terms of the ISDA Master Agreement, in computational code and enabling execution through a technology solution. These guidelines are supported by the publication of a Common Domain Model (CDM) in 2019 that establishes common digital representations of key derivatives events and processes. More recently, ISDA has expanded this program of work to develop guidelines in relation to contracts commonly used in equity and interest rate derivatives markets.

While derivative transactions and the flow of trade serve different purposes, they are similar in that there are standard contracts that are entered into by a wide range of participants in the same industry, with a common understanding of the core components of the parties overall relationship that will be governed by the contract.

Precedent is powerful when change is needed.

For example, the International Chamber of Commerce, like the ISDA, provides substantial benefit to the global trading system through the development and maintenance of model contracts and clauses commonly used to govern cross border commercial relationships and the publication of International Commercial Terms (Incoterms) that are widely adopted on a global basis to establish common representations of terms of trade. The ICC also provides central guidance and support to commercial chambers globally, who perform critical roles in the issuance of commonly used trading instruments including Certificates of Origin (COO). Guidance developed by the ICC demonstrate the important and substantive role that the ICC can play in leading and enabling widespread commercial adoption of digital trade documentation supported by common standards and rules. This includes:

  • guidance in relation to the development, use and acceptance of Electronic COO (eCO);
  • development and maintenance of the UCP500 (and its electronic derivative, the eUCP) establishing commonly used rules on documentary credits and similar common rules in relation to International Standby Practices and Demand Guarantees in international trade financing; and
  • more recently, the launch of the ICC Digital Standards Initiative (DSI) focused on the development of a digitised global trade environment.

Similar to the role played by the IDSA, the ICC is a critical link in developing effective interfaces between commercial participants and commercial practice, policy makers and regulators with the common goal of developing and maintaining harmonised and digitised frameworks to support cross border commercial transactions and global trade financing.

What can business leaders do?

Contracts are often children with many parents within an organisation – they are originated by commercial teams, negotiated by the lawyers, executed by delegates and managed by no one. This adds friction in contracting process, asymmetries in information and potential misalignment of priorities across stakeholders and risk of dissonance between the commercial deal as documented and commercial activities that will occur post execution. Additionally, and fundamentally, it also makes it unclear who ‘owns’ the contract and the roles and responsibilities of stakeholders across the business in relation to its operation.

At a foundational level, business leaders need to position the lifecycle of contracts – from the establishment of commercial discussions, to the negotiation, documentation and execution of their commercial terms to the active management of contracts in accordance with their terms and applicable commercial rules – as a ‘front office’ strategic and business priority, which relate to the improvement of the customer experience and the generation of revenue, and not to the ‘back office’ of process and paperwork. This will establish the behaviours, systems and practices needed to facilitate the transition to paperless trading relationships. These approaches will require:

  • multi-dimensional perspectives – ensuring that the commercial teams, legal, compliance, procurement and supply chain teams connect early and frequently through the origination and negotiation of commercial relationships leading to the formation of commercial contracts and the management of contracts in force;
  • planning for potential scenarios – integrating the analysis of factors (counterparty, market and regulatory) and associated scenarios that may influence the relationship between the performance of the documents and commercial activity and actions into front end commercial activity (pre execution) and back end (post execution management);
  • drafting to the commercials – simplifying and, wherever possible standardising core contracts, drafting to align with intended commercial arrangements;
  • drafting for readability – adopting standards and norms in the construction of clauses and concepts that can be understood by humans and computational analysis;
  • drafting for flexibility – agreeing and adopting clearly defined rules to enable the review, variation or adjustment of material terms in response to external trigger events;
  • digitising process and practice – wherever possible executing contracts digitally, centralising access points and storing contracts electronically; and
  • extracting commercial value from data – collecting, storing and structuring data related to contracting processes and the contracts themselves to identify and analyse trends and themes that can be integrated into proactive risk management, customer experience improvement initiatives and improvement in cash conversion cycles and other economic performance indicators.

Modernising, standardising and digitising the management of commercial contracts enables contracts to be appropriately managed as an ‘asset class’, maintaining line of sight of the commercial value, key risks and key obligations at an individual asset and category level and taking proactive and reactive actions when key variables are compromised or threatened.

 

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