Overview

This whitepaper suggests how the security capabilities of Secro’s tokenized e-bill of lading (eBL) can be used to reduce the banks’ commodity trade finance portfolio risk, thus helping to better comply with Basel IV requirements. The chart below provides a comparison between the risk associated with traditional, paper bills of lading versus the risk-mitigation factors provided by Secro tokenized e-bill of lading.

• Banks can significantly benefit from using Secro tokenized eBL over traditional paper-based bills of lading. Firstly, Secro tokenized eBL ensures faster processing times. The electronic transfer of title is instantaneous, reducing delays associated with couriering physical documents. This speed avoids any “unsecured financing” period, during which the bank does not hold any collateral.
• Secondly, Secro tokenized eBL enhances security and reduces the risk of fraud. The blockchain technology underpinning Secro eBLs provides a tamper-proof and transparent record of ownership and transfers, mitigating the risks of document forgery and loss.
• Finally, complete digitization of the bill of lading process simplifies manual and administrative tasks, providing real time alerts on documents of title ownership, activities, errors, potentially dishonest behaviors

The following pages outline the believed impact of the risk-reduction capabilities of Secro Tokenized eBL on Basel IV key areas, with specific regard to Commodity Trade Finance.

1. Basel IV Overview

Introduction

Basel IV is an extension and refinement of the Basel III regulatory framework, developed by the Basel Committee on Banking Supervision (BCBS). It aims to strengthen the regulation, supervision, and risk management of banks globally. Basel IV introduces more stringent capital requirements, risk-weighted asset calculations, and measures to improve the comparability and transparency of banks’ capital ratios.

Key Components

1. Enhanced Risk Sensitivity: Improved risk sensitivity in the standardized approaches for credit risk, operational risk, and market risk.
2. Leverage Ratio Framework: Introduction of a leverage ratio buffer for global systemically important banks (G-SIBs).
3. Output Floor: Implementation of an output floor to ensure that the capital requirements based on internal models are not less than a certain percentage of the standardized approach.
4. Operational Risk: Revision of the operational risk framework to incorporate the Business Indicator Approach (BIA).
5. Market Risk: Introduction of the Fundamental Review of the Trading Book (FRTB) to better capture market risk.

2. Basel IV and Commodities as Collateral

Commodities as Collateral

Under Basel IV, using commodities as collateral requires banks to maintain substantial capital reserves. This is due to the inherent volatility and liquidity issues associated with commodities. The framework assesses the risk of such assets by assigning risk weights and haircuts, which are deductions from the collateral’s market value to account for potential future price drops and liquidation costs.

Challenges

• Volatility: Commodities can experience significant price fluctuations, which increase the risk of using them as collateral.
• Liquidity: The ease of converting commodities into cash varies, affecting their reliability as collateral.
• Regulatory Haircuts: High haircuts reduce the effective value of the collateral, necessitating higher capital reserves.
• Optimization of funds availability: for larger banks, overall funds availability for commodity trade finance operations might be capped or limited by trade-offs between different activities (e.g.: wealth management, real estate financing, etc..). For smaller banks, the lending limit is capped by the bank’s equity.

3. Typical Risk Weights for Commodities under Basel IV

Risk Weights Assignment

The Basel IV framework assigns risk weights to different types of commodities based on their market characteristics:

1. Gold: Typically assigned a lower risk weight (around 20%) due to its stability and liquidity.
2. Other Commodities (e.g., Oil, Coal, Metals): Generally assigned a higher risk weight (around 100%) due to their higher volatility and lower liquidity.
3. Agricultural Products: Often have higher risk weights due to seasonal and weather-related volatility, typically around 60% to 100%.

Example Calculations under Basel IV

For a commodity like coal valued at $10 million:

• Risk Weight: 100%
• Haircut: 20%
• Adjusted Value: $8 million
• Capital Requirement (at 8%): $640,000

Please see appendix 2 for the full calculation and explanation

4. Detailed Criteria for Risk Weighting and Improvements brought by Secro Tokenized eBL
5. Risk Weighting

Criteria Determining Capital Allocation: Commodities typically attract high risk weights due to their price volatility and lower liquidity. For example, coal often has a risk weight of around 100%, while gold might have a lower risk weight of approximately 20% due to its relative stability and liquidity​ (Deloitte United States)​​ (Bank for International Settlements)​.

Improvement with Secro Tokenized eBL: while inherent market risk still remains, Secro tokenized eBL enhances transparency and security, reducing operational risks and fraud. This can potentially lead regulators to assign lower risk weights to commodities, thus reducing the capital requirements. For instance, improved tracking and verification might justify a reduced risk weight from 100% to a lower percentage, reflecting the mitigated risks.

2. Haircuts

Haircut rationale: The bank imposes a haircut on transactions due to market volatility without hedging protection, particularly for commodities like rice, some grains, cashew nuts, and pig iron. This measure ensures the borrower retains a vested interest in the recovery process in case of default, akin to insurance models. Additionally, it adjusts the collateral’s value to reflect physical market realities. For instance, financing a stock of copper in Zambia involves discounting the market price by the cost of moving the product to a liquid market like an London Market Exchange’s warehouse, accounting for the delta between local and international prices.

Criteria Determining Capital Allocation: Haircuts are applied to the value of commodities to account for potential price fluctuations and liquidation costs. Commodities like coal can have significant haircuts, typically around 20%, due to their volatility​ (Deloitte United States)​​ (PwC)​.

Improvement with Secro Tokenized eBL: Secro Tokenized eBLs provide tight control over the possession and pledgeability of the document of title, and thus over the commodity itself. For instance, Secro Tokenized eBL enables the bank to enter possession of the eBL within minutes of its issuance, instead than after days or weeks. This enhanced capability to obtain possession of the cargo and liquidate the bank’s position even in case of borrowers’ default, can lead to lower haircuts. For example, the haircut for coal might be reduced from 20% to 10%, increasing the recognized value of the collateral and thereby lowering the capital allocation required. Furthermore, the fact that only 1 original, immutable Secro Tokenized eBL is needed and allowed, rather than the usual set of 3 paper originals, drastically reduced instance of possible fraudulent activities.

3. Market Risk Factors

Criteria Determining Capital Allocation: High volatility and low liquidity increase capital requirements for commodities. Banks must hold additional capital to cover potential market risks associated with price fluctuations and liquidity issues​ (Bank for International Settlements)​.

Improvement with Secro Tokenized eBL: Real-time data and the ability to track the shipment history, as well as controlling cargo release, provided by Secro tokenized eBL, can mitigate liquidity risks, and, to some degree, also the volatility risk. For instance, volatility risk can be mitigated the digital nature and instantaneous transferability of the document of tokenized eBL, which enables faster and more flexible commodity re-selling and liquidation. This improved risk management can lead to a more favorable assessment by regulators, potentially reducing capital charges and capital requirements.

4. Exposure at Default (EAD)

Criteria Determining Capital Allocation: EAD represents the extent of exposure at the time of default and is critical in determining capital requirements​ (Bank for International Settlements)​.

Improvement with Secro Tokenized eBL: The precise and real-time data from the Secro tokenized eBL, such as the ability to track at any given time who is the party in possession of the document of title, ensures a more accurate calculation of EAD, reducing uncertainty and potentially lowering capital requirements. Also, the ability to clearly attribute each Tokenized eBL to a digitally identified carrier, shipper, endorsee(s) and consignee (when present), reduces uncertainty and potentially capital requirements. For instance, if a tokenized eBL demonstrates a lower EAD due to improved monitoring, the bank’s capital requirement could decrease.

5. Probability of Default (PD) and Loss Given Default (LGD)

Criteria Determining Capital Allocation: Banks using the IRB approaches estimate PD and LGD, which significantly impact the calculation of risk-weighted assets (RWAs)​ (Deloitte United States)​​ (PwC)​.

Improvement with Secro Tokenized eBL: Enhanced tracking and verification through tokenized eBLs and QR-coded verification can reduce the likelihood of disputes and defaults (PD) and decrease the risk of loss in case of default (LGD). For example, if PD is reduced from 5% to 3% and LGD from 40% to 30% due to the use of tokenized eBLs, the overall capital requirement would decrease.

6. Standardized Approach for Market Risk (SA-MR)

Criteria Determining Capital Allocation: Banks calculate capital charges for commodity risk based on sensitivities to price changes, volatility, and non-linear risks under the SA-MR​ (Bank for International Settlements)​.

Improvement with Secro Tokenized eBL: The transparency and immutability of tokenized eBLs can reduce sensitivities to price changes and volatility, leading to lower capital charges. For instance, lower delta and vega risks due to the secure and transparent nature of tokenized eBLs can reduce the overall capital requirement under the SA-MR.

7. Internal Ratings-Based (IRB) approach

Under the Internal Ratings-Based (IRB) approach Secro can reduce the RWA and improve banks’ ROE by enhancing several key risk factors:

Reduced Risk Weight: Secro tokenized eBLs can potentially reduce the risk weight assigned to commodities by regulators due to improved transparency and security. For instance, a commodity like coal, traditionally assigned a 100% risk weight, can be reduced to 80% with Secro tokenized eBLs. This reduction in risk weight directly lowers the RWA, and by extension, the required capital.

Lower Haircuts: Secro’s tokenized eBLs offer improved liquidity and reduced fraud risk, which can lower the haircut applied to collateral. For example, the haircut for coal may be reduced from 20% (in the case of paper bills of lading) to 10% with Secro tokenized eBLs. This reduction increases the recognized value of collateral, further reducing capital reserves required.

Improved Exposure at Default (EAD): The precise, real-time data enabled by Secro tokenized eBLs allows for more accurate calculations of exposure at default (EAD), reducing uncertainty and potentially lowering capital requirements.

Lower Probability of Default (PD) and Loss Given Default (LGD): With enhanced tracking and verification through tokenized eBLs, disputes and defaults (PD) are less likely, and the risk of loss in the event of default (LGD) is also reduced. These improvements could lower the overall capital requirements, as a decrease in PD and LGD would lead to a lower risk profile.

Operational Efficiency: The automation and digitalization provided by Secro tokenized eBLs significantly reduce manual processing and fraud risk, leading to operational cost savings. This increased operational efficiency contributes to better ROE, as banks can handle more transactions with fewer resources and lower risk.

8. Supervisory Review and Stress Testing

Criteria Determining Capital Allocation: Regulatory bodies assess banks’ resilience through supervisory reviews and stress testing, ensuring adequate capital against commodity exposures​ (Deloitte United States)​​ (Bank for International Settlements)​.

Improvement with Secro Tokenized eBL: The use of tokenized eBLs can provide more accurate and real-time data, improving the outcomes of supervisory reviews and stress tests. Enhanced data quality, auditable history log and reduced risk perceptions can lead to more favorable stress test results and potentially lower capital buffers. For example, if stress tests show that the bank’s exposure to commodity risk is lower due to the use of tokenized eBLs, the required capital buffers might be reduced.

Appendix 1: Comparison of Trade Finance Portfolios

Key Observations

Capital Reserves Requirement: Reduced for Secro tokenized eBL due to lower risk weights and haircuts.

Risk Factor: Significantly lower for Secro tokenized eBL, enhancing compliance with Basel IV requirements.

Operational Efficiency: Higher for Secro tokenized eBL due to automated processes and reduced manual intervention.

The table demonstrates the comparative advantages of adopting Secro tokenized eBL over traditional paper-based bills of lading, particularly in terms of capital requirements, risk factors, and operational efficiency.

Appendix 2 Comparison of Basel IV Requirements for $10M Shipment of Coal

Explanation

1. Risk Weight
   • Paper Bill of Lading: The risk weight for a $10M coal shipment is 100%, reflecting the high volatility and lower liquidity of commodities.
   • Secro Tokenized eBL: Assumed reduction to 80% due to enhanced security and transparency provided by blockchain technology.
2. Haircut
   • Paper Bill of Lading: A 20% haircut is applied to account for potential price fluctuations and liquidation costs.
   • Secro Tokenized eBL: Assumed reduction to 10% due to improved liquidity and reduced risk of fraud.
3. Haircut Value
   • Paper Bill of Lading: Haircut value is $2M, reducing the collateral value to $8M.
   • Secro Tokenized eBL: Haircut value is $1M, reducing the collateral value to $9M.
4. Adjusted Value
   • Paper Bill of Lading: The adjusted value of the collateral after applying the haircut is $8M.
   • Secro Tokenized eBL: The adjusted value is $9M due to a lower haircut.
5. Risk-Weighted Assets (RWA)
   • Paper Bill of Lading: RWA is calculated as $8M, based on a 100% risk weight.
   • Secro Tokenized eBL: RWA is $7.2M, reflecting an 80% risk weight on the adjusted value.
6. Capital Requirement (8%)
   • Paper Bill of Lading: The capital requirement is $640,000.
   • Secro Tokenized eBL: The capital requirement is reduced to $576,000, reflecting lower risk weights and improved collateral value.
7. Risk Factor
   • Paper Bill of Lading: Higher due to the potential for manual processing errors and higher fraud risk.
   • Secro Tokenized eBL: Lower due to enhanced automation, transparency, and security measures.
8. Operational Efficiency
   • Paper Bill of Lading: Lower due to manual processes involved in handling and verifying documents.
   • Secro Tokenized eBL: Higher due to streamlined, automated processes and real-time updates.

Conclusion

Using Secro Tokenized eBL for a $10M coal shipment significantly improves compliance with Basel IV requirements by reducing risk weights and haircuts, thus lowering the capital requirement. It also enhances operational efficiency and reduces the risk factors associated with manual document handling and fraud. This comparison highlights the benefits of adopting advanced digital solutions in trade finance.