Electronic contracting: commodities market players driving changes in shipping as technology advances

Publication March 2017

2016’s surprise uptick in commodity prices confounded the majority of market analysts and commentators. There have been unexpected gains in the key steel-making commodities, iron ore and metallurgical coal, which together account for a very significant proportion of the global dry bulk market. These gains are likely to have been driven by a multitude of factors: cuts in Chinese domestic iron ore production; the loss of 30-40m tonnes of seaborne iron ore following the Samarco Mineração disaster; efforts to stimulate the domestic Chinese property market, and a subsequent rally in steel prices; and a general rebound across the commodities sector, fuelled most recently by the election of Donald Trump as the next President of the USA. There remains a possibility that the price rebound will continue, as we venture into what analysts expect to be the worst cyclone season for many years in the Pilbara region of Western Australia, a key hub for iron ore.

Non-performance risk in a falling market

Owners of, and investors in, dry bulk carriers, together with other market participants, will be watching closely to see whether the prevailing commodity prices will be sustainable in the longer term. Any significant volatility in the daily market prices of commodities heightens the risk of non-performance by purchasers. Traditionally, non-performance by purchasers of steel industry commodities has tended to peak during a rapidly falling market. One of the consequences of moving away from benchmark pricing to a market index-based model is that it appears unattractive to many purchasers to pay an average monthly price for their shipment under a term contract, when indications are that the prevailing spot price over the coming weeks will be significantly lower. There have been a number of instances where a rapidly falling market has resulted in a slew of defaults across the sector.

Technological risk management

There are ways in which exposure to non-performance risks can be mitigated by commodity market participants. Many of these risk mitigants impact on the shipping sector, in one way or another.

Over the past years, we have seen several examples of parties being burned by the issuance or acceptance of Letters of Indemnity – particularly those issued in respect of original bills of lading not being present at the discharge port, prior to the carrying ship’s arrival. Electronic document platforms have for many years been offering electronic bills of lading (eBoLs) as a potential solution to Letters of Indemnity exposure. eBoLs enable data containing the same information contained within physical bills of lading to be submitted electronically and received very quickly after their submission. This means that in cases where the original bills have not reached the discharge port prior to the ship’s arrival, the current practice of transmitting physical bills by courier, and issuing Letters of Indemnity to shipowners and up a chartering chain becomes a thing of the past.

Further streamlining of the commodity contracting and payment process has resulted from the development of electronic payment mechanisms, such as Bank Payment Obligation which relies on data matching, and which may eventually be capable of replacing traditional paper Letters of Credit within the purchasing chain. Electronic Letters of Credit, transmitted through secure channels and subject to electronic Uniform Customs and Practice Rules, are also gaining traction.

Of significant interest within the broader commodities sector, and with the potential to supersede other recent technological developments, is the advent of electronic “smart contracts”. Smart contracts typically operate over “blockchain” (or “distributed ledger”) technology. In combination with such technology, smart contracts may make possible live monitoring of cargoes and transmission of data and documentation in electronic format, which data would themselves trigger payments being made, rather than the traditional reliance upon pieces of paper being couriered around the world and manually processed at various stops along the way. As it develops, this technology may have the ability to reduce the risks associated with traditional non-performance and physical document fraud, which producers, traders, shippers and receivers of goods have previously been susceptible to.

Trials of smart contracts over blockchains have successfully been effected in respect of containerised cargoes – the logical first step. While we may be some time away from the full arsenal of this developing technology applying to dry bulk cargoes such as iron ore, it is in the interests of all major market participants to drive technological advancements within the sector, in order to achieve a greater degree of security in performance and to mitigate risks attaching to defaults and to fraud.

Despite industry enthusiasm, it is important to bear in mind that, along with the benefits, the technology may bring with it some risks that will need to be mitigated or otherwise addressed operationally.

For example:

  • whether a smart contract is a legally binding contract will need to be addressed in the model of smart contract deployed (as some models simply automate processes in the absence of contractual terms and conditions).  Templates for standard transactions might need to be developed for industry-wide acceptance;
  • liability will need to be allocated where, for example, a smart contract performs in a way that is not expected (perhaps because there are bugs in its coding), or does not perform at all (for example because of some other factors unrelated to the parties to it, such as data corruption during transmission);
  • there are risks relating to electronic fraud and cybercrime, (although similar risks, relying on significantly less sophisticated technology, already exist in respect of paper documents).  Blockchains rely on public key infrastructure cryptography, and a “hacker” might gain possession of a participant’s private key (perhaps to misappropriate or redirect payments); and
  • governance relating to participation in a blockchain solution will need to be agreed and receive industry-wide acceptance, so that the rules relating to participating in the solution as a whole (not just in particular transactions) are understood. This may require adoption of common operating and security standards by those participating.  A degree of industry co-operation would therefore be required.

This final point, regarding industry-wide acceptance, will become increasingly relevant to shipowners.

Impact on the shipping sector

As some of these methods of technological risk mitigation are being trialled, evaluated and adopted by producers and traders of commodities, shipowners will come under increasing pressure to adopt new technology which has the effect of limiting exposure to market participants – including risks to shipowners themselves. In order for blockchain technology and smart contracts to succeed, similarly as with eBoLs, there will need to be support from all aspects of the industry, including from shipowners. As has been the case - with some degree of success in recent years - with eBoLs, we expect that the major producers will be pressing all other commodities market participants to adopt these new technologies. It appears from early trials that a number of major banks active within the commodity markets will be supporting a move towards electronic solutions. The productivity gains, efficiencies and risk mitigants which can be realised across the entire sector are significant. As this technology gains conceptual buy-in amongst producers, traders and end users, they will be demanding increased electronic capabilities from ship owners, and favouring those who are able to commit to providing electronic solutions.

Reducing the risk of claims under Letters of Indemnity issued due to original bills of lading not being present at the Discharge Port in time would be one reason why shipowners may wish to move to adopt this technology. With end to end electronic contracting, bank processing time for Letters of Credit and courier time is eliminated, meaning that eBoLs would arrive very shortly after they are submitted, and the scope for delay claims is greatly reduced.

Brokers will be increasingly asked to source ships capable of issuing eBoLs and, eventually, monitoring cargoes electronically in real time. It may eventually be the case that charterparties themselves will be replaced by smart contracts concluded over blockchain technology. Charterers, depending on their broader role in the industry, will likely be driving these changes, as they will often themselves be the producers, traders or end users who will ultimately benefit from the efficiencies and productivity gains which would ensue.

Conclusion

While the advent of electronic solutions has been threatened since as far back as the 1970s, the potential productivity gains and efficiencies which blockchain technology and smart contracts offer commodities market participants may eventually drive the uptake of electronic solutions across the shipping industry. While eBoLs on their own have proved not to be sufficiently appealing in terms of productivity gains to prompt the entire market to move, seamless end-to-end electronic contracting may offer the types of efficiencies which will make them impossible to ignore. This may well gather the necessary critical mass within the affected industries so as to tip the scales in favour of the broad adaptation of electronic solutions. This may finally bring an end to the traditional papertrail which the shipping industry has relied on for hundreds of years.

These developments will certainly present their own challenges, in that traditional paper bills of lading and Letters of Credit are supported by international conventions, custom, and are the subject of centuries of common law. There will certainly be interesting and sometimes unforeseen legal issues arising along the way.

However, as times progress, it is likely that the benefits of moving towards electronic end-to-end solutions, rather than the heavy reliance on physical paper documents, will become clear for all to see. Shipowners who are proactive in embracing the new technologies, rather than continuing to demand reliance on traditional paper documentation, are those who are likely to see the long term benefits of these advancements, although it may not all be smooth sailing ahead in the short term.


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