Why We’re Building Sapling
Generating economic growth and returns through the revival of community lending for SMEs
SMEs: Powering Global Growth & Job Creation
Worldwide, SMEs represent over 90% of businesses and are responsible for 50–70% of employment globally. According to the World Bank, emerging economy SMEs contribute up to 40% of GDP and create 7 out of 10 jobs. SMEs not only generate employment but are also a driver of innovation and socio-economic change; women lead up to one-third of all businesses globally.
From a macro perspective, the IMF estimates that in geographies where SME financial inclusion lags the most, closing the gap could positively impact GDP (about one percentage point) and help increase employment by creating 16 million jobs by 2025.
Small and medium-sized enterprises are the world’s growth engine — helping SMEs grow means providing opportunities to a significant proportion of the world’s population. That’s our mission.
A $5.2 Trillion Problem
Like any business, SMEs need credit financing to grow, whether it’s hiring more employees, buying machinery, investing in new technology or providing working capital. However, unlike larger businesses, SMEs across the world struggle to get access to affordable capital. When they do manage to access capital, they face higher transaction fees and interest fees than larger businesses.
The International Finance Corporation (IFC) estimates that 65 million firms, or 40%-50% of micro, small and medium enterprises in developing countries, have an unmet financing need of $5.2 trillion every year.
So if most people recognise the importance of SMEs, the obvious question is, why does a financing gap exist?
Loss of Local Banking: The Evolution of Banking
One answer lies in the evolution of the banking industry. The history of banking is essentially the history of lending, with the origins of banking being traced back to the first recorded loans in the temples of ancient Mesopotamia.
From its inception, successful lending has been based on trust and proximity.
Lenders have always thrived more when they have deep knowledge of the borrowers’ ability to repay loans whilst borrowers have always achieved more affordable repayment terms when they have established a positive relationship and long-term credibility with the lender.
Banking scaled through relationships
Until recent decades, the banking industry continued to scale based on relationships. A significant number of small community banks or credit unions and local branches of larger banks provided a wide distribution network for lending products to SMEs. As a result, SMEs never used to be far from a local bank manager who understood their business and happily provided affordable finance.
Banking mergers and consolidation
However, in more recent times the evolution of the banking industry has meant that access to finance for SMEs has become much more challenging. As a result, the number of commercial banks has reduced in most countries. For example, the number of commercial banks in the US peaked at 14,496 in 1984, but by 2020 about 10,000 of these banks had disappeared, with bank closures and an increased number of mergers seeing a rapid decline in local financing options for SMEs.
Human vs algorithms
The mergers and sector consolidation led to greater centralisation of operations. Lending decisions have gradually moved from local to central lending officers. These centralised, remote lending officers have limited knowledge of the businesses applying for loans and rely instead on computer algorithms.
The financial crisis of 2007–2008 only served to exacerbate the problem; increased capital requirements have made it harder for small and mid-sized banks to broaden their loan books and serve SMEs whilst overall lending by small and mid-sized banks seems to be in decline.
Large Consolidated Banks Find it Difficult To Service SMEs
As a consequence of this evolution, the average SME is faced with a banking system that has stacked the odds against them. The banks that have survived the industry’s transition and the financial crisis are predominantly global players searching for hefty fees whilst minimising their cost-income ratio through maximum centralisation. And who’s to blame them? It essentially costs a bank as much to process and underwrite a small loan as processing and underwriting a large loan, and given large loans are more profitable the clear incentive for modern banks is to lend to large institutions. In a lot of cases, it simply does not make sense for large banks to lend to SMEs, these SMEs are starved of financing and the countries those SMEs reside in miss out on SME-driven growth opportunities.
So Where Does This Leave SMEs?
SMEs have limited local financing options outside of family and friends, given the centralisation of banking operations and a lack of local banking relationships. Instead, SMEs are funnelled into a “one-size-fits-all” loan application process by banks and shadow banks, which can be arduous, intimidating, and take an excessive amount of time.
Banks will look for SMEs to provide their credit history, a cash flow history, and cash flow projections (usually in the form of a business plan), and a raft of other documentation ranging from personal financial statements to income tax returns. Suppose the SME has managed to surmount those obstacles, judged by someone from the bank’s central operations who they have never met. In that case, they are then invariably asked for collateral to secure the loan — something they may or may not have readily available.
At the end of this painful test of stamina, with collateral committed, the SME is then faced with higher interest rates and transaction fees than a larger business would experience — even if the SME has secured finance, it is rarely at an affordable rate or without onerous terms.
In developing countries, SMEs face even more challenges
In developing countries there is even less choice, as the banking system is in its infancy. For example, in Africa 57% of people do not have a bank account. The IFC estimates SMEs in developing countries have an unmet financing need of $5.2 trillion every year. SMEs that can borrow are often subjected to extremely high interest rates. Self perception is also a problem. Women entrepreneurs in Africa are more likely to self-select out of the credit market because of perceived low creditworthiness.
Limitations of Current Defi Credit Offerings to SMEs
Currently, there are four main on-chain credit protocols that do not require borrowers to commit crypto collateral — Maple Finance, Goldfinch, TrueFi and Tinlake. These pioneers have made impressive progress and established the unsecured crypto lending market, however we think there are limitations to what is currently being offered, specifically when lending to SMEs.
Multiple intermediaries absorb efficiency
Many of the existing protocols lend to intermediaries rather than connecting to end borrowers, i.e. the end SME borrower is not on-chain. Multiple layers of fee-taking institutions such as funds of funds, mezzanine funds, and fintechs sit between the lender and end borrower, meaning lower lender APYs and higher borrower APR costs.
The SME borrower is not on-chain
As the final SME borrower is not on-chain the SME cannot build an on-chain credit profile — therefore lenders cannot take advantage of on-chain transparency to assess the creditworthiness of the borrower. With end borrowing off-chain, transparency is more challenging, potentially leading to situations like the recent Celsius meltdown.
Pool liquidity limitations
Current protocol structures either lock up lenders for fixed time periods or route lenders through a senior consolidation pool. There is limited or no liquidity in the lower pools. Unknown and rising gas costs limit decision-making unless large sums of money are used, locking out smaller lenders.
Advantages of Fully On-Chain SME Borrowing via Pool Managers on Layer 2s
Sapling will look to address the limitations of current unsecured lending protocols by bringing SME borrowers on-chain via Layer 2 blockchains.
The SME borrower is on-chain
On-chain transparency allows SMEs to build public credit profiles, enabling them to drive down their borrowing costs over time and open up more significant sources of capital. Better transparency also means a more robust system for all.
Pool Managers create efficiency
Lenders add funds to lending pools managed by Pool Managers that lend directly to the SME borrower, meaning that there is only one intermediary and associated cost. Less intermediates means better rates for both the lender and borrower and more profit. In addition, Pool Managers will be incentivised to form relationships with their Borrowers (better relationships mean lower probability of default). Borrowers will be incentivised to repay loans and form relationships with their Pool Managers to protect their most important capital source.
Lower gas (transaction) fees on Layer 2’s such as Optimism make new protocol dynamics possible for smaller lending pools. On Ethereum mainnet depositing, withdrawing, creating a lending pool, and creating a Dex pool costs $100s in gas fees. This means only large value transactions are viable, therefore only large value pools are able to gain any liquidity on mainnet. Layer 2 fees on Optimism are around ten times lower than mainnet allowing smaller pool values and liquidity. Markets work better when large gas fees do not hamper depositors, borrowers, and liquidity providers — the market is open and more liquid for all.
Projected Market Size
Global credit to non-financial corporations
The total global credit to non-financial corporations is $86 trillion.
Global SME lending market
According to the data for the largest 41 countries collated by Bank for Internal Bank Settlements (BIC) the international SME lending market size is approximately $14 trillion.
Developing nations’ unmet SME debt requirements
The IFC and the SME Finance Forum found that 65 million enterprises, or 40 percent of formal micro, small and medium enterprises in developing countries (i.e. not even the entire global market), have an unmet finance need of $5.2 trillion a year. The Consultative Group to Assist the Poor estimates the SME market size to be over $8 trillion.
Growth in community lending via credit unions
At the same time, as the global banking industry has consolidated and the gap in SME financing has grown, credit unions have seen significant growth. According to the World Council of Credit Unions, at the end of 2020, there were 86,451 credit unions in 118 countries. Collectively they served 375 million members (up 29% YoY from 2019) and oversaw US$2.1 trillion in loans.
The growth of DeFi lending protocols has been explosive
In the last two years the two main lending protocols, Compound and Aave, have grown from practically zero to billions in loans. From June 2020 to June 2022 Aave grew from $15m to $16bn in loans and Compound from $25m to $5bn in loans. That’s approximately 525x growth in two years.
SME lending is at the point of inception
We estimate that SME lending via the main “non-crypto collateral” lenders, Maple, Goldfinch, Truefi and Tinlake, is around $250m as of June 2022. These protocols tend to lend to funds or intermediaries that sometimes lend to Fintechs which then lend to SMEs.
If SME crypto lending grows anything like as fast as Defi lending it will provide a massive opportunity.
Uncollateralized lending is working on Ethereum
There are the four credit protocols (mentioned above) with active marketplaces on Ethereum connecting liquidity providers with large prime brokers and financial institutions. We estimate that the combined total value of outstanding loans across these four protocols is $1.2bn as of June 2022. Current volumes are very encouraging and there is certainly room for huge growth. Some of the lending from these four protocols does end with SMEs.
Kiva has proven that lenders will fund the underserved
An off-chain lender, Kiva, has shown successfully in recent years that lenders have an appetite to provide underserved SMEs with capital. Kiva is a non-profit marketplace where lenders can provide SMEs with small-value loans via Kiva’s in-country finance partners. Lenders make zero return on their loans and yet still take all the risk.
Surely there’s minimal demand from investors for a one-way bet with no return?
Actually the opposite is true. Kiva’s 2.1 million lenders have funded over $1.75 billion in loans in over 70 countries with a repayment rate of 96.3% — people want to support small businesses globally and are happy to forgo a return to do so.
Our initial proof of concept test is still working
As we discussed in our origin story post over ten years ago, Tim O’Shea, our Cofounder and CEO, set up community lending in a small Ugandan village to help drive growth. Those lending pools are still running, and the profits help pay for the running costs of the community school. Default rates are zero, APY rates are high for the lender, but very affordable and profitable for the borrower. The loans continue to help the local entrepreneurs build their businesses. The only constraint is capital.
The average US savings account APR is 0.07% whilst there is $5.4 trillion of unmet developing nation SME debt requirement on top of an SME global lending market of $14 trillion.
Currently, around $250m is being lent to SMEs on crypto rails despite the Defi lending market growing at least 525x in the last 2 years.
Fully on-chain lending to SMEs through community-run, liquid lending pools on Ethereum Layer 2s. This drives economic growth while generating strong returns for lenders due to the huge untapped funding gap.
“As humanity transitions from the industrial age to the informational age, our old institutions are decaying. In this overton window we have a once in a lifetime opportunity to build new, better, fairer institutions.”
Anon (via Greenpilled, How Crypto Can Regenerate the World by Kevin Owocki)
We’re recreating the old community-based banking system using crypto.
Yes, it’s obvious, but it makes perfect sense.
Sapling is to Community Banking as Bitcoin is to Gold
Sapling is an open-source, decentralized, unsecured lending platform enabling anyone (individual, institution, community, syndicate, family, or group of friends) to provide credit to SME borrowers without running a full-stack banking operation. Our goal is the most simple and secure lending Web3 platform in the Ethereum ecosystem, owned by the Sapling community, and focused on returning SME lending to a relationship-based business founded on trust.
Sapling as a Driver For Crypto Adoption
Borrowers: Access To Capital
In developing countries where there is minimal mature financial infrastructure, borrowing will be the magnet that will attract people to use Sapling and hence crypto. Much like mobile phone technology facilitated the bypassing of landline internet connections as people in developing countries went straight to mobile, we believe that borrowing will be the force of attraction that brings people straight into crypto, leapfrogging the cumbersome current banking system.
Lenders: Higher Yields
On the other side of the marketplace in developed countries yield-starved investors will be drawn to use Sapling to get better returns. Lenders will also be able to support the communities close to them.
Sapling — It’s Time To Grow 🌱
Now is the right time — the reasons are compelling:
- We are passionate about helping SMEs to grow and contribute to economic growth.
- The current banking system is not supporting SME growth, creating an immense global financing gap.
- The market size is significant, and the demand from lenders is proven.
- Pioneering protocols have shown that uncollateralized lending on Ethereum and Layer 2 blockchains can work.
- Lending and borrowing will be the magnetic force attracting people into using crypto, helping borrowers and lenders turn their backs on a financial system that doesn’t want to support them.
SMEs require a new approach
Whilst emerging credit protocols are blazing a trail, there are clear differences between those protocols and Sapling. Sapling is building a platform to lend to SMEs directly. Many of the current protocols are lending to funds or fintechs, which then lend to a few SMEs. Others simply lend to larger institutions or intermediaries. As the on-chain uncollateralized lending and credit market evolves these are all valid models to pursue; Sapling has chosen to focus on simplification by directing capital straight to SMEs through Pool Managers.
Closing the SME financing gap
Sapling is the next step in the evolution of uncollateralized lending on the blockchain, with a mission to bring SME lending fully on-chain, making it cheaper and more efficient for all parties. We believe in closing the SME financing gap by democratising the lending process from lender to the end borrower and using the unique characteristics of blockchain technology to build an ecosystem founded on verifiable trust.
By building a lending infrastructure that puts money into the hands of SMEs who so badly need it, we create a platform that allows SMEs to improve productivity, improve the livelihoods of the people who run them, those who work for them, and everyone who relies on the products or services they provide.
Read next: Introducing The Sapling Protocol