SME Credit Availability — How Blockchain will solve the Credit Gap
Economic activity is largely driven by Micro, Small and Medium siye Enterprises(SMEs). However, credit availability to this segment of companies is highly limited, both in developed and developing economies.
In this article current solutions for SME lending are reviewed. Specifically, how Blockchain and DLT (Distributed Ledger Technology) can increase access to capital and reduce the credit gap.
In order for more SMEs to obtain credit, innovation in Fintech and financing models is required. Blockchain based applications tracking payments, contract fulfilment, and many other aspects of business activity, will enable lenders to extend credit to borrowers which currently are not considered creditworthy. Standardized financial instruments, natively issued on Blockchains, will enable near real time reporting and securitization of loan books previously not possible.
Economic activity and employment in the world is largely driven by Micro, Small and Medium Size companies, referred to as SME. The International Finance Corporation, estimates that of the 4oo million SMEs in the world, about half of the companies have unmet credit needs of between $2.1 trillion to $2.6 trillion(1).
These numbers mean nothing to the entrepreneurs and company owners looking to finance an expansion, a working capital need, or a seasonally higher inventory . The problem is massive in developing countries, but equally frustrating is the lack of credit access in developed economies with well built out banking services. A lack of access to credit results in lower growth overall and reduced employment, as SMEs employ the majority of the workforce in the world.
Even in markets with very low and negative interest rates, SMEs have to rely on equity and alternative sources of capital. In the case of Switzerland, the credit gap is massive, with 68% of all SMEs not accessing any form of banking credit(2).
With the arrival of large data pools, machine learning and venture capital with an interest in Fintech, new platforms and business models have emerged providing credit solutions focused on SMEs. These Fintechs are growing rapidly, but the credit volume and market reach are still limited in comparison to the credit volumes required to impact economic activity in a meaningful way.
I am convinced, that new Blockchain enabled solutions will dramatically increase access to credit.
In this article current solutions for SME lending are reviewed and we explore how Blockchain and DLT (Distributed Ledger Technology) can increase access to capital and reduce the credit gap.
Fintech solutions addressing SME credit not based on Blockchain
Over the past decade, Fintech startups have established a number of business models to address the credit needs of SMEs. The platforms can generally be categorized in three different areas:
- P2P Lending platforms, such as Lending Club, where capital providers can select specific credit opportunities sought by companies
- SME Balance Sheet Lending, such as Kabbage, where companies can obtain term loans, and other forms of financing
- Invoice financing, such as Aprila and Lydia, where companies can sell or finance invoices
The above business models and products are possible with the advent of machine learning, data pools created from business records, online accounting systems, and scraping information from public sources and social media. Service providers charge elevated rates, but as terms are typically short, borrowers do not notice annual rates which can be in excess of 25% and even much more.
In addition, even the most innovative Fintech startup is not ready to lend to borrowers with a higher risk, whether this risk is elevated due to the lack of data or its proprietary risk assessment based on complete information. Therefore, innovation on the financial products side is needed in order to enable larger numbers of SMEs to access credit.
Blockchain enabled solutions targeting credit needs
Blockchain and Distributed Ledger Technology, introduce trust and the ability to share data, information, proofs of many things, in a secure and reliable manner. This means that entities, which do not trust each other, can trust a shared ledger, which is immutable and contains information that can not be manipulated.
Blockchain enabled solutions are now deployed in Trade Finance, where joint efforts by industry participants like we.trade are creating complete transaction environments, enabling documentation, messaging and settlement. Such platforms are targeted at specific use cases and allow incumbent banks and service providers to maintain at least some involvement in the future of their industry. Adoption appears quite slow considering the high cost for services and complexity in trade finance.
Supply Chain Finance is an area where the opportunity for innovation through a shared trusted blockchain ledger is evident and large. Imagine any company can efficiently agree on the status of shipments, payments and outstanding services with its suppliers. The efficiency to be gained is almost beyond comprehension. Back in 2017, I described an early pilot project by Foxconn for the first three tiers of its supply chain. Recently, the company indicated that this application will be migrated into an Ethereum based platform, complete with smart contract execution capabilities (referred to as “chained”).
By deploying a trusted universal ledger which confirms outstanding orders of Foxconn to its suppliers (in a permissioned, i.e. secure and restricted access environment), the company enables third party financing providers to offer working capital financing to its suppliers, improving the financial stability of its entire supply chain. In addition, Foxconn suppliers do not have to engage individually with providers of factoring services, which would be more costly than the Foxconn facilitated platform.
Why is Supply Chain Financing such an ideal area for the deployment of Blockchain enabled solutions? Because of the wealth of information and facts that can be shared by all participants. In the case of Foxconn, it started in a limited fashion and with the premise that any supplier participating is a verified supplier of Foxconn on its platform (think of it as an “intranet” like in the 90s — or was it 80s?? :-). In the future, such applications will be built in large, open access environments (think if them as the “internet”), where encrypted information is readily accessible by actors who have the authority to do so. We will record supplier reliability, proof of physical delivery, proof of service delivery, proof of quality standards, and other key business actions. Based on this verified information, lending decisions will be enabled to an extent currently not conceivable.
Building the Future Tech Stack for SME Lending
The future stack for SME lending will require the combination of fintech innovation over the last decade and the newly emerging Blockchain technologies.
Thanks to fintech innovation, capital providers can base lending decisions on more data, refined algorithms, and API enabled transaction environments. With the advent of crowdfunding and P2P lending, more capital is being deployed in the SME sector.
Combining these innovations with the trust and verification engine that Blockchain enabled applications offer, I expect significant innovation in SME lending and SMEs abilities to access credit. The first innovative solutions are deployed in private, permissioned environments (equivalent to “intranets” of the 1990s), only serving a selected participants and severely limiting credit volumes. Before we can move to public encrypted environments, a number of foundational technology questions such as Zero Knowledge Proof and traceability of metadata will have to be solved. At present, innovative startups such as param.network are combining the benefits of open sourced technology with a permissioned layer on demand, resulting in accessible but controlled environments, which are expected by enterprise customers.
Innovation in supply chain financing will emanate from large corporations seeking to bring stability to their supply chains, and providing access to working capital financing for their suppliers by third parties. Innovation in trade finance will come from conglomerates and alliances seeking to maintain some kind of influence on a complex, but highly profitable line of business.
Standardized financial instruments (e.g. based on ACTUSFRF), natively issued on Blockchains, will enable all parties to refer to the same calculations, and verified and audited stream of cash flows. Such standards will drive near real time reporting and allow for the securitization of loan portfolios, previously thought impossible.
Financial innovation will be needed — Blockchain is not enough
Despite my conviction that the described combination of fintech innovation with blockchain enabled “proof of [anything]” will result in real innovation in lending to SMEs, technology alone will not impact the persistent problem that little of the liquidity pumped into capital markets is reaching SMEs.
However, instruments where riskier SME borrowers can access credit. Given the restrictions banks face with capital requirements and risk management, I believe the answer will be found in off-balance sheet portfolio approaches in combination with algorithmically standardized smart contracts describing the obligations and enabling near real time reporting on the portfolio.
(1) Alternative Data Transforming SME Finance; IFC Washington, 2017.
(2) Étude sur le financement des PME en Suisse en 2016; Institut pour les services financiers de Zoug (IFZ) Haute école de Lucerne — Économie; Juin 2017