The new era of smart contract based supply chain financing
The future of trade and supply chain finance is tokenised_Part 3
DeFi — A glimpse of the future of trade and supply chain finance
The tokenisation of assets coupled with innovation in payment tokens will usher a new era in trade and supply chain finance.
For a glimpse of what the future might look like, just take a look at decentralised finance (DeFi). The value of tokens locked in various DeFi lending protocols has increased 30 folds over the last 12 months to $30 billion. Still a tiny fraction of, say, the global corporate bond market ($41 trillion), DeFi has the potential to become a big part of the global financial system.
DeFi lending protocols use smart contracts (a computer program residing on a blockchain) to receive a token in exchange for another token. An user interacts with a smart contract via a decentralised application (dApp). If you are a lender, you will receive interest. If you are a borrower, you will pay interest. The interest rate (on protocols such as Compound) is set programmatically by supply and demand. For Dai, the interest is replaced by stability fee which is effectively the interest for borrowing Dai. Again, this is set automatically by market forces. There is also over-collateralisation to protect against falling collateral prices. The smart contract also tracks collateral price through an automated program (an oracle).
So DeFi lending is similar to traditional collateralised lending in most respects. The main differences are that they are permissionless and decentralised — anyone can borrow or lend — and fully automated.
Collaterals used in these lending protocols are native blockchain tokens like Eth or Dai, they are not exposed to counterparty risks but only market risks. Counterparty risk is one of the main obstacles to bridge traditional finance to DeFi. Invoices pledged as collateral may not be collected.
DeFi lending protocols are working on overcome this obstacle or coming to a realisation that they either face the concentration risk of cryptos or the counterparty risk of real world assets — Either ways, diversification will help to sustain the system and make DeFi lending becoming mainstream.
With assets being tokenised and payment tokens becoming increasingly available, trade and supply chain finance can benefit from smart contract technology to streamline and automate lending process. The difference is of course that it can not be permissionless due to regulations such as Know-Your-Customer. The advantage over DeFi, however, is that, if implemented on a permissioned blockchain, privacy can be preserved. This is particularly important as supply chain sourcing is a source of competitive advantage for many companies.
In a recent report, the World Bank recognises the potential of smart contracts in supply chain finance and insurance, in enabling more SMEs to to access finance. Specifically, smart contract-based financing could lead to process improvement, fraud reduction and enhanced transparency.
Let’s talk on how this could be done in trade and supply chain finance:
Financing with tokens and smart contracts
Trade and supply finance refers to financing activities relating to a cross border transaction or along the supply chain respectively. Traditionally a bank-originated asset class, increasingly non-bank financiers have entered this space.
An exporter ships goods to an overseas buyer and issues an invoice. The invoice will then be settled by the buyer 30 days, 60 days or 90 days later. The exporter needs working capital therefore sells or pledges the invoice to a bank or a non-bank financier. The financier discounts the invoice and pays the balance to the exporter.
With smart contract-based financing, a single or a batch of tokenised invoices is sold or pledged as collateral for a loan. The financier first advances an amount (typically 90% of the value of invoices) and collects payment directly from the buyer. Each stakeholder has a wallet which has been topped up with payment tokens. As a buyer pays an invoice (or the invoice can initiate automatic payment on due date as discussed earlier) it will set off the advance with the remaining amount being automatically transferred to the seller, after deducting a fee for the financier.
Pre-shipment finance can also be obtained. A financier advances working capital to an exporter on the back of inventory they own. Typically, there is a tripartite relationship between the company, the financier and a collateral manager who provides safe custody of the inventory on behalf of the financier. The inventory in this case is collateral for the financing.
As inventory is tokenised, it is used as collateral for a loan via a smart contract. The loan is disbursed to the SME’s wallet.
- Funders fund the Lender (warehouse facilities)
- SMEs supply to Buyers and issue an invoice. Once invoices are accepted by approved Buyers they are tokenised
- Lender buys/finance tokenised invoices. Approved Buyers pay Lender directly via wallet which automatically set off the financing
- Inventory can also be used as collateral. In this case, the service of an external collateral manager or a commodity exchange is required for safe custody. Once the inventory is sold and an invoice is accepted, the invoice token replaces inventory token as collateral.
- Purchase Orders (PO) from approved Buyers are also accepted as collateral. Once PO has been accepted, SMEs can apply for financing. When goods have been produced and delivered, an invoice token will be issued in place of the PO token as collateral for the financing
- Once asset tokens have been built up to certain threshold they will be sold to an SPV for securitisation. A bond token will be issued to investors and DeFi
- Proceeds from securitisation is used to repay Funders or to originate more assets
- Collections from assets/Buyers is used to fund redemption of principal and interest to investors
As raw materials are processed into products, raw material tokens are replaced by finished product tokens under the same lending contract. Once the inventory is sold and an invoice is raised, the collateral token transforms into an invoice token, still within the same lending smart contract. Once the invoice is paid either by a financier or the buyer, the proceeds automatically trigger the repayment of the loan plus interest with the remainder being transferred to the borrower’s wallet. This process saves SMEs from having to obtain multiple facilities, incurring extra costs, but also affords lenders with better loan issuance and monitoring as the physical flow inventory synchronises with its financial and information flows.
Financing can be obtained even earlier in the supply chain. Based on the strength of a purchase order, a financier can lend to the exporter so they can buy the inventory for export or for processing into products. Again, in this case, the purchase order will be tokenised, allowing the smart contract to release a loan. Once the inventory has been bought or further processed, the inventory token will replace the purchase order token as collateral. Once inventory is sold, the invoice token will again replace the inventory token all the way to payment of the invoice in the manner described above.
The above funding use cases increase in riskiness to financiers which is reflected in funding costs and other conditions such as collateral ratios or advance rates. Also, as the value of collateral is derived from the price of inventory, it is important that there is a reliable price reporting mechanism (an oracle) to the smart contract. The smart contract can also set a liquidation ratio i.e when the value of collateral falls and the borrower fails to either top up more collateral or to repay part of the loan, the lender can step in to seize the collateral to recover the loan.
Trade and supply chain finance distribution
Tokenisation will not just transform the origination of trade and supply chain finance but also its distribution.
This asset class is generally low risk with little correlation to other asset classes. However, so far it is quite difficult for non-bank investors to get exposure to. At the same time, banks find it expensive, from a regulatory capital perspective, to lend to sector. Many banks have retreated from trade, particularly commodity trade finance. This has led a rise of specialist supply chain financiers such as Greensill and private credit funds. Unlike banks, these organisations can’t raise retail deposits so securitisation is one of the main funding sources. Even for banks, securitisation is attractive as a way to move assets off their balance sheets whilst still maintaining the customer relationship.
Since supply chain loans are tokens themselves they can be pooled together according to some eligibility criteria before another token representing a bond/fractional interest in the asset pool being issued to investors. As each pool is a smart contract that holds asset tokens, bond investors can always track performance of underlying assets — there can never be a loss of nexus between the security and the assets backing it up. This was one of the major causes of the 2008 Global Financial Crisis.
With the bond token being issued on a public blockchain like Ethereum, it will open up to opportunities in DeFi. In a near future, the consumers of chocolate made from Niche Cocoa’s materials can invest in a token backed up by a portfolio of Niche Cocoa’s invoices and inventory. They can further increase their investment through using the bond token as collateral in DeFi lending protocols to obtain more liquidity.