Developed in partnership with Defactor — Traditional lending is broken and a “quick fix” won’t do it for SMEs
Special thank you to the Defactor team for this interesting perspective on the lending space!
According to the World Trade Organization, small- and medium-sized enterprises (SMEs) represent over 90% of the business population, 60–70% of employment and 55% of GDP in developed economies.
Despite the crucial role they play, many SMEs struggle to access the funding they need to keep operating and growing.
The problem is made obvious by looking at the situation in trade finance, where the unsatisfied demand for funding before the start of the pandemic was $1.5 trillion. Since then, the finance gap has exponentially increased and ICC has estimated it’s now close to $5 trillion. And this is not limited to trade finance either. SMEs across all industries are seeking new ways to access capital.
According to the World Economic Forum, “Banks and fintech platforms have been scrambling to find a way to address that need, but the existing frameworks for servicing businesses are not a great fit.”
This is because the framework that is preventing SMEs from accessing fundings is the same that traditional institutions have no interest in fixing, as doing so puts their very existence at risk.
Traditional lending is broken
The current framework puts banks at the center, leaving them as the sole judge of who is creditworthy who is not. Unfortunately, SMEs have less formalised governance processes and publicly available information. They often operate in emerging sectors and don’t have enough assets to be used as collateral. This makes them too risky for the banks, but that’s not the only issue.
Other barriers SMEs face when it comes to lending include a cumbersome and costly client support infrastructure, a lengthy and tedious application and assessment processes, demands for impeccable credit scores, and financial statements used as the only means to show business performance.
As businesses explore alternative avenues to fundings, they may try to list in capital markets, often failing to attract enough capital. Investors in these markets prefer to mitigate risk by betting on larger and more established companies, which most of the time already have access to liquidity.
If that sounds like a self-perpetuating mechanism, where established institutions and investors minimise their risk-exposure by only backing organisations that offer solid guarantees… it’s because it is.
In this uneven playing field, big players get bigger and small companies get dwarfed and left out of the credit game.
With severe cash flow restrictions, one in five SMEs can’t embark on new projects, while 9 in 10 say this situation is preventing them from growing, according to TradePlus24.
Along comes DeFi
Since its inception, DeFi has been seen as the potential solution to SMEs credit issues.
A blockchain-based form of finance that does not rely on intermediaries, such as banks, means that information can be easily accessed without centralised processing or an existing relationship. This makes client onboarding faster and risk assessment easier to scale.
DeFi is a new paradigm, not just a patch designed to fix the current system. Yet, banks have merely considered blockchain as the opportunity to introduce efficiency to their slow and clunky legacy systems. They have run pilot programs to make bank frameworks more efficient by replacing their traditional processes with digital ones.
However, banks haven’t leveraged the fundamental principles of decentralised finance. They still assess credit risk based on financial statements and use the same old criteria to determine the creditworthiness of their customers.
Instead of addressing SMEs’ need for credit, these efforts were only designed to improve financial institutions’ operating costs. And this is proven by the widening of the finance gap mentioned earlier in this article.
There’s something else to consider. So far the retail sector, using crypto assets as collateral, has dominated the lending side of DeFi. The volatility of cryptocurrencies, the lack of government regulation and the complexity of the technology have deterred companies from entering the new ecosystem.
SMEs’ position is clear — they want in, but the alternatives to access liquidity need to be safe. They want to deal with trustworthy organisations that streamline the onboarding to DeFi for them.
DeFi liquidity is here to stay
SMEs are waking up to the benefits of DeFi liquidity, including:
- Complete transparency without the involvement of third-party intermediaries, such as banks
- Permissionless access, immutability of data, and interoperability of protocols and applications
- Fast processing speed
- Safety against value loss from coin-value-fluctuations — the asset acts as collateral.
However, as it currently stands, DeFi is not solving the problems of liquidity for SMEs. The only way for them to access new fundings is to be onboarded in the new ecosystem as real world asset originators so they can use assets such as letters of credit, royalties, goods or otherwise as collateral.
But the onboarding is happening too slowly, or not at all. That’s because organisations rarely have the time or technical skills needed to build solutions to access or manage liquidity pools.
That’s where partners like Defactor and Centrifuge come into play.
Defactor is an integration layer and a suite of tools that allows traditional businesses to take their existing systems and processes into the DeFi space. Defactor enables SMEs to access DeFi liquidity while providing investors with insight into the underlying assets being funded.
For example, Defactor lets SMEs operating in trade finance to collateralize transported goods, enabling them to enter new funding pathways. It also lets liquid providers enjoy greater security knowing that tangible, physical assets back their investments.
Centrifuge is a network that provides access to fast, cheap capital for small businesses and stable yield for investors without the risk and volatility of crypto assets. With Centrifuge, borrowers can finance their real-world assets, such as invoices, real estate, and royalties with no need for banks or other intermediaries. In this network, providing liquidity is open to everyone and investors receive a return plus token rewards.
Defactor and Centrifuge have entered into partnership in the second half of 2021 to enhance the onboarding processes for new asset originators seeking to obtain liquidity from Centrifuge’s Real World DeFi platform.
Bottom line
DeFi is a new way of thinking for sure. But what it delivers for SMEs in terms of satisfying credit requests puts them in a position to achieve their full growth potential.
The ecosystem is now offering stability through secure technologies and protocols. Moreover, there are reliable players that can provide SMEs with the guidance and support they need to take up the opportunities of the DeFi liquidity, and leave the broken system behind.
Gabriela Ariana Campoverde is Co-Host of the Wharton Fintech Podcast and a second-year MBA student at The Wharton School and Masters student at Penn Engineering. She is passionate about building products for work-class, immigrant communities across the US.
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Gabriela Ariana Campoverde
