Mads Stolberg-Larsen, Head of Fintech and Blockchain at Tradeshift Frontiers discusses how deep-tier financing uses blockchain to follow receivables from lower tier suppliers right up to a big buyer.
The concept of trade finance dates back almost as far as the beginnings of trade itself. Early trading relationships worked on a shared memory of mutual cross-obligations, continuously adjusted and revised. Communities were close-knit, so it was quite easy for individuals to keep track of the relationships different traders held, and their reputation for delivering on a promise. Such transparency created a low-risk environment for lenders to insert financing options between two trading parties in order to reduce friction in the flow of goods.
One might expect things have moved on a little since that time. But the reality is that the core principles of trade finance, as well as many of the underlying processes, have changed relatively little since the days of trading spices and furs with the neighbouring village.
That just about works when trading relationships are static and binary. But in today’s globalised world, supply chains are far more than just buyer supplier relationships. Today’s corporate buyers know their success relies not just on their direct suppliers that produce the goods they need, but also the smaller companies further down the chain that make components that are essential to the finished product.
Even now, the vast majority of these business to business trade relationships still rely on paper records and emails, making the whole system notoriously opaque, prone to delays, errors and even fraud. It’s also a heavily fragmented system, with pockets of information residing in any number of different locations.
Complexity and a lack of transparency are like kryptonite for lenders. As a result, trade financing options are typically only available to established tier one suppliers able to jump through the hoops necessary to convince a lender that they’re a safe bet.
The companies that fall out of the tier one bracket don’t have access to the same financial opportunities because lenders are unwilling to enroll these sellers onto financing programs. Why? Because they lack visibility into the companies, which leads to increased financial risk that makes financing just not worth it.
That should be a worry for big buyers who rely on these smaller suppliers being able to function as part of a broad ecosystem. It’s also unfair on suppliers whose vital contribution, relationships and reputations count for nothing.
Deep-tier financing is about unlocking the value of business relationships to offer access to finance for every supplier, not just the tier one. In other words, banks and other lenders assess risk not just on the relationship a small business might hold with a supplier a little further up the chain, but as part of a wider ecosystem that would typically ladder up to a well-established, highly trusted global buyer.
The key to all of this is to produce a level of transparency into the flow of capital as it makes different hops across the supply chain. This gives banks and other lenders guarantees of where goods are being shipped and where the corresponding sources of revenue are coming from.
Digitisation is a first step on this journey. The introduction of cloud-based technology is already helping organisations get rid of manual siloes by connecting invoicing, approval, payment and working capital lending onto one platform. Not only does this increase efficiency and reduce costs, it also makes the whole process far more transparent. Throw in the carrot of trade financing, and smaller suppliers are more likely to be incentivised to make the change.
Things start to get really interesting when you add in technologies like blockchain, and smart contracts. Smart contracts are automatically executable lines of code that are stored on a blockchain and which contain predetermined rules. In other words, when a smart contract is put in place it serves as a guarantee that everyone is going to get paid.
The mix of smart contracts and blockchain technology makes it possible to tokenize the receivables of sellers with large creditworthy buyers as counterparties. These tokens act as collateral that gives funders the ability to finance companies right through the supply chain. This means sellers can access financing at attractive rates at the large buyer’s cost of funds.
The benefits for sellers through the supply chain are clear. But deep-tier financing isn’t just a one-way street: large buyers at the top of a supply chain benefit as well.
For one, it gives them the opportunity to optimise working capital in exactly the same way that supplier finance does today. But the impact will be even greater given that all suppliers in the supply chain can potentially enroll in the program.
And with more suppliers able to access cheap finance buyers can build more resilient supply chains. Supply chains are comprised of companies of all shapes and sizes, each with their own unique financial position. And they’re constantly evolving, especially in these unstable times. So while a company’s supplier ecosystem may be healthy today it doesn’t mean it will be tomorrow. Giving all suppliers access to finance is the best way to mitigate any risk if its suppliers are struggling for cash and causing issues in your supply chain.
Back in 57 AD, the Roman writer Publillius Syrus coined the term: “Reputation is more valuable than money.” Somewhere along the line we lost sight of this principle in the mire of increased complexity and process. I’m not sure quite what Syrus would have made of technologies like blockchain, but I like to think the idea of a marketplace where reputation and relationships can unlock access to capital right down to the smallest supplier would have struck a chord.
Mads Stolberg-Larsen is the Head of Fintech and Blockchain at Tradeshift Frontiers