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Blockchain and SME Financing | Contribution article in EURObiz

By EU SME Centre | Press Article      14.12.2020     Tags:

New technology offers fresh options for European firms

Access to funding is a common problem for small and medium-sized enterprises (SMEs), and particularly so for European SMEs operating in China where domestic banks prefer to go with the safe option of state-owned enterprises. Renzo Isler, director of the EU SME Centre Phase III, explains how the emergence of blockchain technology may provide new financing options for SMEs.[1]

This article originally appeared in EURObiz Nov/Dec 2020

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In many countries, SMEs are the backbone of the economy. These enterprises are crucial to worldwide economic and social development, as they employ more than half of the global population.[2] A large percentage of SMEs tend to be service-orientated and family-owned in nature, and most have relatively light investment in capital goods, reflecting weak tangible business assets in financial/accounting terms. This is associated with high risk and low creditworthiness under the current prevailing lending standards of banks and financial institutions.

As a result, SMEs are less likely to be able to obtain bank loans than large firms; instead, they rely on internal funds or cash from friends and family to launch and get their businesses off the ground. In addition, SMEs are confronted with a number of sector-specific challenges, such as the lack of information required to conduct business efficiently and scale up operations, or inefficient procedures to process payments and recruit other ancillary services necessary to both grow and/or go global.

Current challenges for SMEs

Bank loans

Obtaining loans from banking institutions can be problematic for SMEs, especially for entrepreneurs in the first stages of building their business. This lack of access leads to limited chances of survival for many SMEs; almost 30 per cent shut down in the first three years of operation due to a lack of funding.[3]

Since the banking crisis of 2008, banks are inherently risk-averse, so their tolerance for SME lending is relatively low. A report from the International Finance Corporation (IFC) estimates that 40 per cent of formal micro and SMEs in emerging markets have annual unmet financing needs of United States dollars (USD) 5.2 trillion.[4]     

Financing

Another challenge for SMEs operating internationally is obtaining trade finance. Like many forms of credit provision, trade financing is a key component in the success of SMEs, but it is not always easy for them to obtain. SMEs face lots of hurdles in their quest for funding, especially when it comes to accessing traditional trade finance products such as letters of credit, forfaiting—selling dues owed at a discount in exchange for cash—or trade credit insurance in import/export businesses.

Cash flow issues

Inability to bring in capital causes enormous harm to small businesses, stifling growth and causing cash flow difficulties. Businesses need cash flow to pay for materials, start the production process, pay employees or cover other business expenses. For smaller companies, a late payment can be the difference between success and failure.

Limited alternative financing

SMEs nowadays often turn to alternative forms of financing to obtain funds and ease their cash flow issues. Recent years have witnessed—with mixed fortunes—alternative lending vehicles like peer-to-peer (P2P) or crowdfunding, the latter mainly focussed on technology start-ups.

Blockchain technology a promising solution for SMEs

Blockchain and its distributed ledger technology introduces trust and the ability to share data, information or proof of many things in a secure and reliable manner. This means that entities that might not necessarily trust each other can trust a shared ledger, which is immutable and contains information that can’t be manipulated.

While most people associate blockchain with large companies, the technology also opens up new opportunities for SMEs in every sector to solve existing challenges, and enables them to optimise their business and develop new models.

Trade finance

Blockchain-enabled solutions are now deployed in trade finance, where joint efforts by industry participants are creating complete transaction environments that enable documentation, messaging and settlement. Trade finance products are being made more efficient due to transparency and the consensus mechanisms that replace multiple instances of verification and checking.

A joint study by the World Economic Forum and consultancy Bain & Company shows that blockchain technology could play a major role in reducing the worldwide trade finance gap, facilitating trade that otherwise could not take place.[5]

Supply chain finance

Blockchain technology may also contribute to solving the problem of getting supply chain finance (SCF).[6] A bigger segment of the market is nowadays building open account solutions, but because of the difficulty in assessing how deep the supply chain is, financing is often only offered to a few tiers. As blockchain is much more flexible with data than existing digital systems, this technology opens up new possibilities for additional participants in the chain to get SCF.

On the blockchain, both suppliers and buyers have access to necessary transactional information in real-time. Every step of the supply chain process is timestamped and verified by all parties, so information is accurate and immutable. This added level of visibility may also mean that businesses will have more invoice financing solutions available.[7] This transparency may result in faster transaction processing, improved cash flows for suppliers and potentially better rates from invoice finance providers.

SCF is an area where the opportunity for innovation through a shared trusted blockchain ledger is both evident and large. Imagine if any company could quickly and conveniently agree on the status of shipments, payments and outstanding services with its suppliers. The efficiency to be gained is tremendous.

Smart contracts

One of the most attractive features of blockchain is its potential to offer SMEs smart contracts, which not only define the terms and penalties around an agreement in the same way that traditional contracts do, but also automatically execute and enforce those pre-agreed terms and conditions (without the need for middle agents). Many labour-intensive and expensive business processes can easily be replaced at little cost in this way.

The largest benefit smart contracts could bring is single digital records for customs clearance. Smart contracts can also represent an invoice—or any similar financial document—and be used as collateral to support a loan. Smart contracts would help mitigate credit risk, lower fees and remove barriers to trade.

Funding/collateral

Blockchain technology has the potential to completely transform our approach when it comes to SME funding. Blockchain could help revive P2P lending practices by digitising what was once a manual process, increasing transparency and fostering trust between lenders and borrowers.  

The disintermediation element of blockchain makes it significantly easier and faster for SMEs to raise funds through equity. The removal of these barriers reduces the need for complicated paperwork, while the automated nature of the process may mean that commissions, excessive brokerage fees associated with selling shares and other overheads can all be left behind.

Looking forward

The future for SME financing will require a combination of innovation in fintech, financing models and the newly emerging blockchain technology. Blockchain-based applications tracking payments, contract fulfilment and many other aspects of business activity allow capital providers to base their lending decisions on more data, refined algorithms and application-programming interface-enabled—defining how various software and devices can interact—transaction environments.

Standardised financial instruments developed in a digital environment enhanced by blockchain will enable all parties to refer to the same calculations, as well as to verified and audited streams of cash flows. Such standards will result in near real-time reporting and allow for the securitisation of loan portfolios, which was previously thought impossible.

The adaptation of blockchain technology, facilitated by the process of asset digitisation, could revolutionise not only the way we look at risk, but also allow innovative solutions to price, hedge and manage risk in financial markets and the real economy as a whole. Its adaptation will eventually give lenders elevated capabilities and renewed confidence to extend credit to borrowers who are currently not considered creditworthy. 

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The EU SME Centre is a programme funded by the EU, managed by EASME and DG GROW, and participated in by a consortium of four chambers and a business council. The scope of the Centre is to support European SMEs in better understanding the Chinese landscape and help them to develop trade with and investments in China.


[1]This article has been written in cooperation with Brian Bian (卞军), a freelance writer who focusses on innovative technology and financing.

[2]SME Finance, International Finance Cooperation, viewed 9th November 2020, <https://www.ifc.org/wps/wcm/connect/Industry_EXT_Content/IFC_External_Corporate_Site/Financial+Institutions/Priorities/SME+Finance/>

[3] Fundera, Wikipedia, viewed 10th November 2020, <https://en.wikipedia-on-ipfs.org/wiki/Fundera.html>, Georgia McIntyre, What Percentage of Small Businesses Fail (And Other Need-to-know Stats), 14th September 2020 (update), viewed 10th November 2020,<https://www.fundera.com/blog/what-percentage-of-small-businesses-fail>

[4]Global State of Small Business Report, Facebook, 2020, viewed 10th November 2020, <https://about.fb.com/wp-content/uploads/2020/07/Global_State_of_Small_Business_Report.pdf>

[5]Nicky Morris, WEF/Bain: Blockchain Trade Finance Could Boost Trade by $1 trillion, Ledger Insights, viewed 10th November 2020, <https://www.ledgerinsights.com/wef-bain-blockchain-trade-finance-trillion/>

[6]SCF is a term describing a set of technology-based solutions that aim to lower financing costs and improve business efficiency for buyers and sellers linked in a sales transaction; <https://www.investopedia.com/terms/s/supply-chain-finance.asp#:~:text=Supply%20chain%20finance%20is%20a,capital%20at%20a%20lower%20cost.>

[7]Invoice financing is a way for businesses to borrow money against the amounts due from customers. Invoice financing helps businesses improve cash flow, pay employees and suppliers, and reinvest in operations and growth earlier than they could if they had to wait until customers paid in full: https://www.investopedia.com/terms/i/invoice-financing.asp.

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