What is the Blockchain and how is it affecting SME finance?

Over the last 10 years or so, payment terms of companies have increased from an average of half a day to two and a half days, as a way of better managing cash flow and maintaining working capital in larger firms. As a result of this, it translates into an average of 120 day payment terms, which means businesses may not receive final payment 4 months after the invoice is issued.

SMEs face around £3tn of late payment debt a year, and it’s one of the most frequently labelled pain-points faced. As a result, the growing fintech community have developed a series of off-balance sheet finance solutions, offering SMEs up-front payment, less the cost of interest they charge for the privilege of receiving funds, sometimes in as little as 24 hours. As a result, suppliers accessing this type of funding have the ability to grow quickly, access funding that was not originally available to them, and reduce cumbersome backend accounting processes and siloed work from remittance, reconciliations and finance teams.

One of the most recent technological innovations, coined the ‘next revolution after the internet’ is the use of the blockchain, and in the world of alternative finance, there’s a real application which has recently been tried, and is poised to potentially disrupt the industry over the short to medium term future. Trade finance, which is the umbrella term for the financing of importing or exporting of goods / services domestically and internationally is full of cumbersome paper-heavy practices, inefficiencies and is predicted to be worth £3tn a year, which is why one focus of blockchain integration is within the trade financing space.

In summary, the blockchain has potential in trade and supply chain finance for the following reasons:

• Ability to digitally timestamp parts of the supply chain process
• Settlement of the payment can be streamlined
• When digital assets are transferred from party to party, it can be verified by several peers in a network
• Contracts can be automated
• The ‘truth’ is a single real-time source held simultaneously across the blockchain network

One of the biggest bottlenecks in buyer-seller networks are the siloed IT infrastructures, financial systems and ledgers held in different data warehouses. The inability for systems to ‘speak’ to one another also creates inefficiencies, especially when contract terms or small clauses are changed mid-transaction. Coupled with the added complexity of integrating these systems (and the significant opex costs incurred) and the risk of such large projects not working, solving these issues are difficult in any medium or large company.

Plug and Play Bitcoin? We think not

Blockchain could rewrite the books and allow interconnectivity of various finance and IT systems, as well as real-time changes which overwrite ‘older versions’ of contracts, for example, whilst maintaining the integrity and security of current systems due to the underlying principles of the blockchain (which we’ll go on to talking about later). 

But let’s not get ahead of ourselves. Supply chain and trade finance are complicated, and so are the IT and financial systems within large companies.

As a real example, many trades, especially in the US use wire payments, which flow through numerous banks, or perhaps SWIFT payment, which allows just a few lines of text per transaction. This a huge bottleneck for many businesses, banks, auditors and finance professionals, and this black box makes it tricky to get a real time snapshot of company performance, cash flow or when payments might be due.

The problem comes down to trust (or mistrust), given the numerous parties involved in distributed information which can change during a process; insurers, brokers, suppliers, banks, regulators and IT suppliers.

Blockchain 101

The blockchain is a network of computers (or people with computers) who are known as miners, enabling digital transactions. 

The blockchain is peer to peer and anonymous allowing payments of digital currencies such as bitcoin or etherium. The scripting language can often be compared to ‘escrow’ i.e., securely stored and verified funds or opposed to the role of a Federal Bank.

Blockchain is a big deal. According to Juniper Research, some $290m dollars has been invested into blockchain startups in the first half of 2016.

How could the blockchain be applied to address this issue?

The ownership of receivables (e.g. purchase orders or payables) can be distributed on a blockchain. With the blockchain, the automation of payment to the supplier can be triggered upon preprogrammed conditions (e.g. the goods are received and verified by the buyer).

As a real example, say you’re a supplier of goods to a retailer, and your inventory management system detects that your warehouse is running low on stock, let’s say a particular line of clothing. At this point, a purchase order is automatically raised and sent to the clothing supplier. The supplier verifies (digitially) that they have sufficient stock to ship those goods to the business, and automatically issue an invoice, which is also stored on the blockchain (essentially an electronic ledger). Once the buyer receives the invoice, they could provide an e-signature or multisignature, which is a ‘promise to pay’ upon receiving the goods or on an agreed due date. The buyer can then either pay this invoice or the terms given, or factor (sell) the invoice ahead of the sell date to a financier. The financier would also have access to the digital assets held on the blockchain, and can assess risk accordingly to price the finance. 

In this case, the blockchain will replace the need for the process of conventional escrow, and miners play a part in a cooperative authority to approve the release of funds.

Speaking to Ben Kahn at Concordata, a distributed ledger platform, he suggested one way the blockchain could work when putting together a smart contract between several parties.

“Companies who mistrust their partners keep separate versions of the shared ledger to be sure they can independently guarantee it as correct, signed off, secure etc. For big networks and/or complex data/document sets, the result is a lot of re-keying, cross-checking and correction, and duplication of documents, data and process.”

This is how it works:

1. One party creates or imports the list of data items and rules for how they can be updated.
2. They add parties to the contract, who instantly see identical information in their systems.
3. Each parties may propose additional fields or rules, if required, until the contract is ready
4. When all have provided signed approval for each item, rule and party, the contract goes live.
5. Only updates which meet the agreed rules are accepted, and these are replicated to each ledger
6. When all systems have approved update, proof of consensus is written to the blockchain

Each party can use a console to see real-time evidence of alignment, consensus and lockdown.

Bitcoin is not a simple ‘slam-dunk’

The implementation of bitcoin is far from easy and can be very time consuming.

Anti-money laundering (AML) procedures and know your customer (KYC) protocols will also need to be monitored closely to ensure trade finance maintains the rigour and industry standard if transactions are to be done. Fraud is still a problem which is being combated in the trade finance sector. Kevin Beardsley at Elliptic recently said: “There is a big concern when a company is engaging with bitcoin, they may inadvertently be mishandling proceeds of crime, and not be able to identify those to the standards the industry requires”, which is down to the anonymity and peer-to-peer nature of cryptocurrencies.

In order for trade finance to be fully integrated into some form of blockchain solution, it will need mass adoption from larger corporates, to pave the way for a paradigm shift from the heavily paper-based ‘rekeying’ view of supply chains to true integration of the technology across different systems.

Future of Trade

The global factoring industry is worth around $2tn per year and growing at around 10% a year, and given that trade finance is well adopted and recognised around the world, huge opportunities around big data, the blockchain and cryptocurrencies, and fintech could increase efficiencies and be a key player in trade.